Sirak Thesis

Mekelle University
College of Business and Economics

Department of Management
Factors Affecting Non-Performing Loans: In Case of Commercial Bank of Ethiopia
By:
Sirak Aynalem Argaw
A Thesis Submitted in Partial Fulfillment of the Requirements for the Award of

Masters Degree in Business Administration
Principal Advisor: Teshome Desta (Assistant Professor)

Co-Advisor: Mearg Tesfay (Assistant Professor)
June 2016
Mekele, Ethiop
Acknowledgements
First and foremost, Thanks to almighty God for the successful completion of this thesis. The
completion of this study would have not been realized without the help of others and I would like
to take this opportunity to thank everyone who helped and supported me.
First I would like to greatly express my utmost gratitude to my principal advisor Teshome Desta
(Ass. professor) for his guidance, continual advice and follow-up, concern, and systematic
review of the thesis. I would also like to thank my co-advisor Mearg Tesfay (Ass. professor) for
his invaluable comments, encouragements and professional guidance in accomplishing this thesis
and make it successful.
A great thanks and special gratitude is addressed to all credit experts of Commercial Bank of
Ethiopia because of giving me the required data voluntarily to conduct my research. Without
their kind cooperation, this study would not have been complete and became a reality. In this
regard, my special thanks go to Solomon Assefa and Yonatan Gebre for their special effort to
assist.
In addition, I would like to forward my warm appreciation and respect to my friends Ato Melaku
Habte, Ato Binyam Tadesse and Ato Chernet Ayalew for their invaluable contribution, and more
importantly, their constructive comments and guidance throughout the whole process of the
thesis. Furthermore, my indebted gratitude expressed to my staff members W/ro. Etetu Desta;
W/t. Lelise Tesfa; W/ro. Tigist Franco; Ato Tofik Rahmeto; Ato Meskelu Ayano; and Yoseph
Degu for their support and willingness to cover my part at work.
Last but not least, my indebted gratitude expressed to all of my families for their encouragement
in completing this research paper, especially for my mother Gete Mamo; my beloved sister
Kibrework Beriso.
Sirak Aynalem Argaw
June 2016
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Statement of Declaration
I hereby declare that the work which is being presented in this thesis entitled “Factors Affecting
Non-Performing Loans: In Case of Commercial Bank of Ethiopia” is original work of my
own, has not been presented for a degree to any other university and all the materials used for the
thesis have been duly acknowledged.
__________________________ ____________________
Sirak Aynalem Argaw Date

(Candidate)
ii
Statement of Certification
This is to certify that Mr. Sirak Aynalem Argaw has carried out his research work on the topic
entitled “Factors Affecting Non-Performing Loans: In Case of Commercial Bank of
Ethiopia”. The work is original in nature which has not been submitted to any University and
suitable for submission for the award of Master of Business Administration in International
Business at Mekele University.
Principal Advisor Co-Advisor
Teshome Desta (Assistant Prof.) Mearg Tesfay (Assistant Prof.)
Signature___________________________ Signature____________________
Date________________________________ Date_________________________
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Statement of Approval
This is to approve that the thesis prepared by Sirak Aynalem Argaw, entitled: “Factors Affecting
Non-Performing Loans: In Case of Commercial Bank of Ethiopia” and submitted in partial
fulfillment of the requirements for the degree of Master of Business Administration in
International Business complies with the regulations of the University and meets the accepted
standards with respect to originality and quality.
Internal Examiner: G/Egziabher Berhane (Ass. Professor)
Signature_______________Date______________
External Examiner: Abdurezak Mohammed (PhD.)
Signature______________Date_____________
Chair Person: Hailay G/Tinase (PhD.)
Signature______________Date_____________
iv
List of Acronyms
BLUE Best Linear Unbiased Estimators
CAR Capital Adequacy Ratio
CBE Commercial Bank of Ethiopia
CER Cost Efficiency Ratio
CGR Credit Growth Rate
CLRM Classical Linear Regression Model
GDP Gross Domestic Product
IMF International Monitory Fund
LDR Loan to Deposit Ratio
LGR Loan Growth Rate
MENA Middle East and North Africa
NBE National Bank of Ethiopia
NPA Non Performing Asset
NPL Non Performing Loan
ROA Return on Asset
ROE Return on Equity
SWIFT Society for Worldwide Interbank Financial Telecommunication
OLS Ordinary Least Square
US United States
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Operational Definition of Terms
The following words and phrases will have the under mentioned operational meaning throughout
the research report;
Non Performing Loans (NPLs): - The ratio of bad loans to total loans per year.
Loan Growth Rate (LGR): - Current year loan minus previous year loan divided by current
year loan.
Loan to Deposit Ratio (LDR): - The ratio of total loans to total deposits per year.
Cost Efficiency Ratio (CER): - The ratio of operating expenses to operating income per year.
Return on Equity (ROE): - The ratio of net income to equity per year.
Capital Adequacy Ratio (CAR): - The ratio of total equity to total asset per year.
Asset Growth Rate (SIZE): - Current year asset minus previous year asset divided by Current
year asset.
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Abstract
This study investigates the factors affecting Non-Performing Loans of Commercial Bank of
Ethiopia during the period from 2002 to 2015. The variables were chosen based on findings from
the previous literatures. A mixed research approach and explanatory design were adopted in
carrying out this research. Secondary time series data were collected from audited annual
reports and performance reports of the bank; and the required ratios were calculated. In
addition, 12 credit experts from the concerned departments and functional units responsible for
lending matters in the bank were interviewed. Multiple linear regression equation was used to
estimate the model using SPSS version 20 software. The results obtained from regression output
indicated that among the studied variables, loan to deposit ratio; financial performance
measured in terms of return on equity; and capital adequacy were found to be statistically
significant determinant of NPLs. On the other hand, loan growth, cost efficiency and bank size
were statistically insignificant in affecting NPL. The findings from the interview result indicates
that, variables such as poor credit risk assessment, focusing on collateral based lending, poor
loan monitoring and follow-up, poor banker’s skill in dealing with lending matters, undiversified
loan products, short loan life and lack of credit advisory practices were also the bank specific
factors that affect NPLs of CBE. The study suggests that focusing on these NPL indicators could
further reduce the probability of default while extending credit in the future. Further studies
were recommended by including macroeconomic and other bank specific variables; and by
increasing the sampled periods.
Key Words: Commercial Bank of Ethiopia, Non-Performing Loans (NPLs), Loan Growth Rate
(LGR), Loan to Deposit Ratio (LDR), Cost Efficiency Ratio (CER), Capital Adequacy Ratio
(CAR), Return on Equity (ROE) and Bank Size (SIZE).
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Table of Contents
Acknowledgements .......................................................................................................................... i
Statement of Declaration................................................................................................................. ii
Statement of Certification .............................................................................................................. iii
Statement of Approval ................................................................................................................... iv
List of Acronyms ............................................................................................................................ v
Operational Definition of Terms .................................................................................................... vi
Abstract ......................................................................................................................................... vii
List of Tables ................................................................................................................................. xi
List of Figures ............................................................................................................................... xii
CHAPTER ONE: INTRODUCTION ......................................................................................... 1
1.1. Introduction ...................................................................................................................... 1
1.2. Background of the Study .................................................................................................. 1
1.3. Statement of the Problem ................................................................................................. 3
1.4. Research Objective(s) ...................................................................................................... 7
1.4.1. General Objective ..................................................................................................... 7
1.4.2. Specific Objectives ................................................................................................... 7
1.5. Research Hypothesis ........................................................................................................ 8
1.6. Scope and Limitations of the Study ............................................................................... 10
1.6.1. Scope of the Study .................................................................................................. 10
1.6.2. Limitations of the Study.......................................................................................... 11
1.7. Significance of the Study ............................................................................................... 11
1.8. Organization of the Study .............................................................................................. 12
CHAPTER TWO: LITERATURE REVIEW .......................................................................... 13
2.1. Introduction .................................................................................................................... 13
2.2. Theoretical Literature ..................................................................................................... 13
2.2.1. Overview ................................................................................................................. 13
2.2.2. Nature and Definitions of NPL ............................................................................... 14
2.2.3. Classifications of Loans .......................................................................................... 16
2.2.4. Approaches of NPL Determinants .......................................................................... 19
2.3. Empirical Literature ....................................................................................................... 24
2.4. Identification of Knowledge Gap ................................................................................... 29
viii
2.5. Conceptual Framework .................................................................................................. 30
2.6. Description of Conceptual Framework and Summary of the study variables................ 32
CHAPTER THREE: RESEARCH METHODOLOGY ......................................................... 34
3.1. Introduction .................................................................................................................... 34
3.2. Backgrounds of the Organization................................................................................... 34
3.3. Research Design and Strategy ........................................................................................ 36
3.3.1. Research Design...................................................................................................... 36
3.3.2. Research Strategy.................................................................................................... 36
3.4. Data Type and Source .................................................................................................... 37
3.5. Data Collection Methods and Procedure ........................................................................ 37
3.5.1. Data Collection Methods ........................................................................................ 37
3.5.2. Data Collection Procedures..................................................................................... 38
3.6. Data Processing and Analysis ........................................................................................ 38
3.6.1. Data Processing ....................................................................................................... 38
3.6.2. Data Analysis .......................................................................................................... 39
3.7. Model Specification ....................................................................................................... 40
3.8. Ethical considerations .................................................................................................... 41
3.9. Validity and Reliability .................................................................................................. 41
CHAPTER FOUR: RESULTS AND DISCUSSIONS ............................................................. 43
4.1. Introduction .................................................................................................................... 43
4.2. Descriptive Statistics Results and Discussions .............................................................. 43
4.3. Results of Correlation Analysis and Discussions ........................................................... 45
4.4. Tests for Classical Linear Regression Model Assumptions ........................................... 46
4.4.1. Multicolinearity Test ............................................................................................... 47
4.4.2. Hetroscedasticity Test ............................................................................................. 48
4.4.3. Normality Test ........................................................................................................ 49
4.4.4. Autocorrelation Test ............................................................................................... 49
4.5. Results of Regression Analysis and Discussions ........................................................... 50
4.5.1. Goodness of Fit Statistics........................................................................................ 52
4.5.2. Screening the Model ............................................................................................... 53
4.5.3. Interpretation and Discussion on the Significant Independent variables ................ 55
4.6. Results of Key-Informant Interview .............................................................................. 58
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4.6.1. Bank Related Factors .............................................................................................. 58
4.6.2. Borrowers Related Factors ...................................................................................... 62
CHAPTER FIVE ........................................................................................................................ 63
SUMMARY, CONCLUSION AND RECOMMENDATIONS .............................................. 63
5.1. Introduction ................................................................................................................ 63
5.2. Summary..................................................................................................................... 63
5.2. Conclusions ........................................................................................................................ 65
5.3. Recommendations .............................................................................................................. 66
5.4. Future Areas of Research ................................................................................................... 67
References ..................................................................................................................................... 68
Appendices
x
List of Tables
Table 3.1: Summary of the study variables…………………..…………………………………34
Table 4.1: Summary of Descriptive Statistics for dependent and independent variables………47
Table 4.2: Summary of Correlation between dependent variable and independent variables …49
Table 4.3: Summary Correlation Coefficients of Independent Variables ………………………51
Table 4.4: Definition of variables in the model …………………..…………………………….55
Table 4.5: Summary of First Step Multiple Linear Regression Results…………………………56
Table 4.6: Summary of Second Step Regression Results………………………………………58
xi
List of Figures
Figure 2.1: Conceptual framework of bank specific factors…………………………………......33
Figure 4.1: Rejection and non-rejection regions for Durbin-Watson Test………………………54
xii
CHAPTER ONE: INTRODUCTION
1.1. Introduction
This chapter gives a brief background of the study and introduces the thrust for the research and
the beneficiaries of the study. The chapter also outlines the problem statement, states the
objectives of the study and the proposed hypothesis for the study. The chapter also provides the
significance of the study, scope of the study as well as limitations of the study. In short, it is the
foundation upon which the rest of the research is going and guides the researcher in carrying out
the research.
1.2. Background of the Study
Suryanto (2015) stipulated that, the banking sector in the modern economic system, described as
the heart pumps blood flow in the form of funds to the rest of the economy. To contribute to the
development of the economy of a country, banks play an intermediary role by transferring
excessive funds from the depositors to the borrowers through lending system. According to
Suryanto (2015), this is done so that the collected money in the bank can continue to operate,
because the velocity of money through the bank can earn income from interest and when the
more loans disbursed, the greater bank's revenue earned. In their article Vatansever & Hepsen
(2013), stated that loans generate huge interest income which is a critical measure of the bank’s
financial performance and stability. Therefore, banks are expected to contribute to the
development of the economy through financial intermediation where, the collected money
granted in such a way that earns maximum profit.
Despite of the intermediary role they are expected to play in the economy, banks operate with the
purpose of earning returns without assuming excessive risk. In a study by Alexandri & Santoso
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(2015), to investigate the influence of internal and external factors on Non-Performing Loans and
Jolevska & Andovski (2015), to evaluate the Non-Performing Loans in the Serbia, Croatia and
Macedonia banking system concluded that failure to manage loans, which make up the lion’s
share of banks assets, would likely lead to high Non-Performing Loans, which leads to a low
bank health and low economic growth. Therefore, banks should properly manage Non-
Performing Loan to a minimum level that has little or insignificant effect on its operation.
In the normal operation, all loans granted are not fully subject to collection and free of risk.
Some portions of the loan portfolio have a probability of uncollectable and may threaten the
financial stability of the bank, which leads to increase in Non-Performing Loans. Sizeable
volume of Non-Performing Loans signals the existence of financial fragility and a cause of worry
for banks management and regulatory authorities (Suryanto, 2015). On the other hand, low Non-
Performing Loans suggests relatively a more stable financial system (Adebola, Yusoff &
Dahalan, 2011). Hence, banks need to properly follow and ensure the collection of the funds they
are granted so as not to lose their significant source of income and maintain a stable financial
position. A Non-Performing Loan (NPL henceforth) according to Saba, Kouser & Azeem
(2012), is defined as a sum of borrowed money upon which the debtor has not made his or her
scheduled payments for at least 90 days. NPLs according to Guy (2011), cited in Joseph, Edson,
Manuere, Clifford & Michael (2012), are also commonly described as loans in arrears for at least
ninety days. Therefore in this study, NPLs are loans that are ninety or more days delinquent in
payments of interest and/or principal (Bexley and Nenninger, 2012, cited in Joseph et al. 2012).
Theoretically there have been so many reasons why loans fail to perform and the factors
associated with NPLs of banks are numerous and vary across countries. According to Saba et al.
(2012), the factors associated with NPLs of banks can be broadly classified as macroeconomic
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and bank specific. The macroeconomic factors according to Suryanto (2015) are external
variables that are not related to internal bank management but reflect the economic, legal and the
surrounding natural environment that can affect the loan quality of banks in common as
operating within the same economic setting. The bank specific factors on the other hand, refer to
those factors which characterized individual banks and usually associated with the specific
policy choices of a particular bank such as loan growth, performance, the quality of the loan
portfolio and operational efficiency (Saba et al. 2012).
Njeru (2012), argue that, for effective management of NPLs, it is very critical for banks in
developing countries to understand and focus more on the management of bank specific factors
which they have more control over and seek practical and achievable solutions to address NPLs
problems. In line with its importance, according to Hassan et al. (2015), it is worthwhile to study
deeply and find out the most important bank specific factors associated with NPLs of banks in
developing countries like Ethiopia. Therefore, generally, the main purpose of this study is to
investigate the bank specific factors that affect NPLs in Ethiopia specifically in case of
Commercial Bank of Ethiopia (CBE).
1.3. Statement of the Problem

In the process of allocation of resources from depositors to borrowers through lending system,
banks while making profits, encounter credit risk. Credit risk is inherent to lenders and it
measures the financial exposure associated with the money lend to borrowers. Ahmad & Bashir
(2013) indicated that whenever financial vulnerability is examined; main emphasis is placed on
NPLs. Among various indicators of financial stability bank’s NPLs assume critical importance
since it contemplates on the asset quality, credit risk and efficiency in the allocation of recourses
3
to the productive sector (Jameel, 2014). Consequently, banks are expected to trace deeply the
determinant factors that affect NPLs so as to effectively manage their assets.
Many research works have been carried out around the globe by considering bank specific
factors as important determinants of NPLs. For instance, Shingjergji (2013), found out that
capital adequacy ratio, the loan to asset ratio and interest rate margin as the most important
factors associated with NPLs in the Albanian banking system. Hassan et al. (2015) on the other
hand shows that credit assessment, credit monitoring, rapid credit growth, interest rate charged
by banks and bankers’ incompetence are the most important bank specific factors associated with
NPLs of Pakistani Banking sector. The more recent study by Suryanto (2015) showed that the
bank specific variables that significantly affect the NPL of regional development bank in
Indonesia are the level of efficiency of banks (ROA and ROE), mortgage interest rate and
liquidity of banks.
Boudriga et al. (2009) found out that foreign participation coming from developed countries,
high credit growth, and loan loss provisions are the most important bank specific factors that
affect NPLs of Middle East and North African (MENA) countries. Louzis et al. (2011) found out
bankers’ incompetence and management quality as the most important bank specific factors
affecting NPLs of banks in Greece. Makri et al. (2012) on the other hand, found out that capital
adequacy ratio, rate of NPLs of the previous year and return on equity are bank specific factors
strongly affecting NPLs rate of Euro zone banking system. Saba et al. (2012) identified the level
of loan portfolio have effect on NPLs of US banking sector. Messai and Jouini (2013) found out
that return on assets, the change in loans and the loan loss reserves to total loans ratio are the
most important bank specific factors affecting NPL in Italy, Greece and Spain. Jameel (2014)
found out that capital adequacy ratio, credit deposit ratio and lending interest rate are the most
important bank specific factors that affect NPLs in Pakistan. The most recent study of Alexandri
4
& Santoso (2015) found out that the level of efficiency of the bank (ROA) as the most important
bank specific factor that affect NPLs of banks in Indonesia.
Although the previous studies undertaken on the bank specific factors that determine the
occurrence of NPLs of banks across countries have contributed substantially to the literature,
their findings may not be applicable to other countries like Ethiopia due to their inconsistent
findings. Therefore, this fact justifies the existence of empirical gap in the literature and calls for
a research to find out the most prevalent bank specific factors that affect NPLs of banks in the
Ethiopian context.
In this regard, very few scholarly works have been carried out in Ethiopian banking sector. For
instance, the study of Wondimagegnehu (2012), Zelalem (2013), Gadise (2014) and Anisa
(2015) need to be worth mentioned. Wondimagegnehu (2012) have tried to identify the bank
specific factors that determine NPLs of Ethiopian banking sector from bank employees using
questionnaire and concluded that, poor credit assessment, failed loan monitoring,
underdeveloped credit culture, lenient credit terms and conditions, aggressive lending,
compromised integrity, weak institutional capacity, unfair competition among banks, willful
default by borrowers and their knowledge limitation, fund diversion for unintended purpose,
over/under financing by banks ascribe to the causes of loan default.
On the other hand, Zelalem (2013) have examined the macroeconomic and bank specific
determinants of NPLs of banks in Ethiopia using a mixed research approach. The study found
out that among the bank specific variables studied: loan growth, financial performance and
operational efficiency are the most important and statistically significant variables affecting
NPLs. Gadise (2014), have also examined the macroeconomic and bank specific determinants of
NPLs of banks in Ethiopia using quantitative research approach and secondary data. The study
5
found out that, return on equity and capital adequacy ratio has statistically significant effect on
NPLs. Anisa (2015), conducted a study by employing secondary data and found out that deposit
rate, loan to deposit ratio and lending interest rate had positive and significant impact on banks
NPLs.
Though the studies have undeniably contributed to the subject matter, there is a research gap yet
to explore. First of all, the study of Wondimagegnehu (2012) was more of explanatory and did
not show the statistical relationship and significance of bank specific variables and NPL
sufficiently. Moreover, the study did not sufficiently show how the factors studied correlate with
NPLs of banks.
Even if there are so many bank specific variables, Anisa (2015) employed secondary data of
(cost efficiency, deposit rate, loan to deposit ratio and lending interest rate). However, there are
other variables such as return on equity and credit growth rate that can determine banks NPL. In
addition, Zelalem (2013); Gadise (2014) and Anisa (2015) disregarded the knowledge and
experience of credit performers who are actually participating in the lending process. Hence, it is
useful to include and study credit performer knowledge and experience.
The above mentioned facts along with the empirical gap in the literature call for a research in
order to deeply find out the most important bank specific factors that affect NPLs of banks in
Ethiopia. Therefore, the study intends to examine the financial data of the fiscal year from 2002
to 2015 using the classical multiple linear regression (CLMR) model in order to investigate the
statistical relationship and significance between and NPLs bank specific variables that the
literature calls for; and find out the bank specific factors that affect NPLs in Ethiopia specifically
in case of Commercial Bank of Ethiopia (CBE). More specifically, the study intends to answer
the following kinds of questions in relation to the factors that affect NPLs: What are the factors
6
that affect NPL in case of commercial bank of Ethiopia? What is the statistical relationship and
significance between bank specific factors and NPLs?
1.4. Research Objective(s)
The study has the following general and specific objectives.
1.4.1. General Objective
The overall objective of the study is to investigate the factors affecting NPLs in case of
Commercial Bank of Ethiopia.
1.4.2. Specific Objectives
The study has the following specific objectives as outlined below:-
1. To examine if there is a significant statistical relationship exists between loan
growth rate and NPL in case of Commercial Bank of Ethiopia.
2. To examine if there is a significant statistical relationship exists between loan to
deposit ratio and NPL in case of Commercial Bank of Ethiopia.
3. To examine if there is a significant statistical relationship exists between cost
efficiency ratio and NPL in case of Commercial Bank of Ethiopia.
4. To examine if there is a significant statistical relationship exists between capital
adequacy ratio and NPL in case of Commercial Bank of Ethiopia.
5. To examine if there is a significant statistical relationship exists between return on
equity and NPL in case of Commercial Bank of Ethiopia.
6. To examine if there is a significant statistical relationship exists between bank
size and NPL in case of Commercial Bank of Ethiopia.
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1.5. Research Hypothesis
To achieve the specific objectives, the study proposed the following research hypothesis based
on the existing theories and referring to past empirical studies for later testing.
Relationship between Loan Growth Rate and NPL
Several studies show different results regarding the relationship between loan growth rate and
NPL. Referring to the previous literature such Hassan et al. (2015) that claim rapid loan growth
is often related with impaired loans and supporting the argument that loan growth as a result of
adverse selection problem, leads to an increase of problem loans, it can be taken as the following
hypothesis:
H1: There is a positive and statistically significant relationship between loan growth rate and
NPL.
Relationship between Loan to Deposit Ratio and NPL
Several studies found various results regarding the relationship between loan to deposit ratio and
NPL. Referring to the research findings of Louzis et al. (2011) that shows loan to deposit ratio
positively affect NPL and supporting the claim that increase in deposits as compared to the loans
shows that banks are more concerned with the quality of loans rather than the quantity and lend
only to the quality borrowers, it can be taken as the following hypothesis:
H2: There is a positive and statistically significant relationship between loan to deposit ratio and
NPL.
Relationship between Cost Efficiency Ratio and NPL
Referring to the research findings of Louzis et al. (2011); and Vatansever & Hepsen (2013) and
supporting the argument that efficient banks are better in managing their resources than
8
inefficient banks they are in a better position to control the level of their NPLs, it can be taken as
the following hypothesis:
H3: There is a negative and statistically significant relationship between cost efficiency ratio and
NPL.
Relationship between Capital Adequacy Ratio and NPL
Previous studies found various results on the relationship between capital adequacy and NPL.
Referring to the research findings of Shingjergji (2013); Vatansever & Hepsen (2013); Jamel
(2014); and Alexandri & Santoso (2015) and supporting the argument that says as capital
adequacy is high enough to cover the potential losses from lending, the lower will be the level of
NPL, it can be taken as the following hypothesis:
H4: There is a negative and statistically significant relationship between capital adequacy ratio
and NPL.
Relationship between Return on Equity and NPL
Referring to the research findings of Louzis et al. (2011); Makri et al. (2012); and Shingjergji
(2013) and supporting the argument that as highly profitable banks have fewer incentives to
engage in high-risk activities, less profitable banks are exposed to engage in riskier activities, it
can be taken as the following hypothesis:
H5: There is a negative and statistically significant relationship between return on equity and
NPL.
Relationship between Bank Size and NPL
Previous studies found various results on the relationship between bank size and NPL. Referring
to the research finding of Louzis et al. (2011) and supporting the argument of Boudriga et al.
9
(2009) that says larger banks have more resources, and are more experimented to better deal with
bad borrowers than small banks, it can be taken as the following hypothesis:
H6: There is a negative and statistically significant relationship between bank size and NPL.
1.6. Scope and Limitations of the Study
1.6.1. Scope of the Study
Commercial bank of Ethiopia provides loans to customers (Agriculture, Manufacturing,
Domestic trade and services, Foreign trade, Building and Construction and Personal Loan),
Loans to banks (financial institutions) and loans to the government in the form of bonds (coupon
bond and corporate bond). In this regard, the study is limited to loans and advances provided to
customers involved in all sectors of the economy by excluding bond disbursement to the
government and loans provided to banks.
Though the macroeconomic factors have their own impact on qualities and performance of loans,
the scope of the study is limited to investigating the bank specific factors. In addition the study
covers time series data of the study variables over the period from 2002 to 2015.
Due to the centralized decision making policy of the bank on lending matters where major
lending decisions are made centrally, geographically the study covered and limited to the main
processes and departments of the bank involved in lending matters at Head office in Addis
Ababa.
Finally, due to the confidentiality of the banking sector in general and the policy for disclosure of
information of the bank in particular, and for ethical reasons, the study not addressed the
defaulters’ response and limited to bankers who are involved in the lending process.
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1.6.2. Limitations of the Study
Given the mentioned scope, the study has the following limitations:
A study of NPLs in Ethiopia needs wider coverage of all factors deemed necessary. However,
the study limited to the bank specific factors only. Consequently, the study lacks the effect of the
macroeconomic factors on NPLs to further explain the findings.
In addition, due to the limited geographical scope the study lacks the response of bankers out of
Addis Ababa. Finally, due to limited scope of the study on the bankers, the study lacks the
defaulters’ response that would make the study result more fruitful.
1.7. Significance of the Study
The study assumes significance in terms of its contribution to scientifically investigate the most
crucial bank specific factors associated with NPLs of Commercial bank of Ethiopia. In fact the
concept is a grown up not only to the developed countries but also to developing countries,
studying and investigating the most crucial bank specific factors associated with NPLs will have
a lot of importance to the existing literature by providing evidence on the bank specific causes
of impaired loans in a developing countries like Ethiopia.
Apart from contributing to the literature, the paper may also have important practical
implications for bank managers and bank regulators (NBE) in the Ethiopian banking system. For
instance, the findings may be used to develop a framework for measuring and assessing credit
risk– an important element of study for the financial stability unit of a central bank. Finally, this
study can be used as a foundation for other researchers who would like to undertake research on
similar and/or related area of study.
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1.8. Organization of the Study
This study is organized into five chapters. Chapter one presents the introduction in which brief
introduction of topic, research problem, research questions, objective of study, and scope and
limitations of the study are addressed. Chapter two discusses literature review in which previous
theories and empirical findings regarding NPLs are explained. Chapter three explains the
research design and methodology that are employed. Chapter four briefly discusses the results
and findings of the study. The final chapter presents the summary, conclusions and
recommendations of the study based on the findings.
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CHAPTER TWO: LITERATURE REVIEW
2.1. Introduction
The reason for reviewing the existing literature is to know what is already known about our area
of interest so that we do not simply ‘reinvent the wheel’. We need a comprehensive review of
literatures in the areas of Non-Performing Loans and its associated factors so as to develop and
identify the problem and research gap, and to come up with appropriate research methods.
Therefore, the following chapter deals with the literature relevant to the study by presenting the
theoretical literature, empirical literature and summarizes theoretical and empirical relationship
and the gap to be researched.
2.2. Theoretical Literature
2.2.1. Overview
Banking sector is an essential part of a nation's economy and represents one of the most
important components of a nation's capital. The principal activity of commercial banks is
allocating resources from depositors to borrower trough lending system. In allocating funds, the
primary objective of bank management is to earn income while serving the credit needs of the
economy. Lending represents the heart in banking industry and the loan portfolio represents an
important component of a bank’s total assets. These assets generate huge interest income which
is a critical measure of the bank’s financial performance and stability. In most banks loans
generate the largest share of operating income and represent banks greater risk exposure (Mac
Donald & Koch, 2006).
Despite the fact that loan is major source of banks income and constitutes their major assets, it is
risky area of the industry. That is also why credit risk management is one of the most critical
activities carried out by firms in the financial services industry. In fact, from all risks banks face,
13
credit risk is considered as the most dangerous as bad debts would impair banks profit. It has to
be noted that credit risk arises from uncertainty in a given counterparty’s ability to meet its
obligations. It is widely accepted that the quantity or percentage of NPLs is often associated with
bank failures and financial crises in both developing and developed countries.
In fact, there is abundant evidence for financial crises in East Asia and Sub-Saharan African
countries, the current global financial crisis, which originated in the US, was also attributed to
the rapid default of sub-prime loans/mortgages. Allocating loans has always been one of the
central pillars of the banking business. Traditionally this marked the start of a long term
relationship with the client, which would continue at least until the maturity of the loan. With the
growth of deposits, banks are supposed to increase their lending. However, when NPLs are high,
the willingness to expand loan reduces. Therefore, we can say that in any lending process, there
is inherent risk of loans being defaulted which leads to the concept of NPLs.
2.2.2. Nature and Definitions of NPL
Loans become nonperforming when it cannot be collected within certain stipulated time period
that is governed by some contract. Nonperforming loans generally refers to loans, which for a
relatively long period of time do not generate income; that is the principal and/or interest on
these loans has been left unpaid for at least 90 days.
The definition of NPL varies across countries; there is no global standard to define NPLs at
practical level and previous studies have defined NPLs according to their needs. Saba et al.
(2012) defined NPL in US banking sector as a sum of borrowed money upon which the debtor
has not made his or her scheduled payments for at least 90 days. A NPL is either in default or
close to being in default. Once a loan is non-performing, the odds that it will be repaid in full are
considered to be substantially lower. If the debtor starts making payments again on a NPL, it
14
becomes a re-performing loan, even if the debtor has not caught up on all the missed payments.
Basha & Ramaratnam (2016), defined NPL (also called Non-Performing Assets) in India as the
assets of the banks which don’t perform (that is – don’t bring any return) are called Non
Performing Assets (NPA) or bad loans. According to them bank’s assets are the loans and
advances given to customers. If customers don’t pay either interest or part of principal or both,
the loan turns into bad loan.
NPL is also defined from institutional point of view. Basel committee cited in Hassan et al.
(2015) defined NPLs as loans which are not paid and their overdue time period is 90 days after
maturity date. More specifically NPL is:
“any loan in which interest and principal payments are more than 90 days overdue; or
more than 90 days' worth of interest has been refinanced, capitalized, or delayed by
agreement; or payments are less than 90 days overdue, but no longer anticipated”.
Under the Ethiopian banking business directive, NPLs are defined as “loans or advances whose
credit quality has deteriorated such that full collection of principal and/or interest in accordance
with the contractual repayment terms of the loan or advances in question” (NBE,SBB/43/ 2008).
Further defined in the directive as:
“Loans or advances with pre-established repayment programs are nonperforming when
principal and/ or interest is due and uncollected for ninety consecutive days or more
beyond the scheduled payment date or maturity”.
Therefore, loans become NPL when it cannot be recovered within certain stipulated period of
time that is governed by some respective laws.
Generally, from the above definition NPL is:
15
i. A loan that is not earning income;
ii. Full payment of principal and interest is no longer anticipated;
iii. Principal or interest is 90 days or more delinquent or;
iv. The maturity date has passed and payment in full has not been made.
2.2.3. Classifications of Loans
Despite its critical importance, there is no well-recognized international standard for recognizing
and accounting for credit losses by banks. Loan can be classified as performing and non-
performing. Performing loan is loan that payments of both principal and interest charges are up
to date as agreed between the creditor and debtor. Generally, loans those are outstanding in both
principal and interest for a long time contrary to the terms and conditions contained in the loan
contract are considered as NPLs.
All banks need a loan classification or grading system to facilitate the monitoring and
management of credit risk in their loan portfolios (NBE, 2008). To identify the loans which are
nonperforming and to calculate and determine the amount of provisions under the current
Ethiopian banking regulations, a bank’s loan portfolio can be classified into five major categories
namely, in order of deteriorating status, pass; special mention; substandard; doubtful; and loss.
Each of these categories has, among other things, a time element before which a loan is
transferred to a lower category. To this end, the NBE issued asset classification and provisioning
directive to provide uniform guidelines for banks operating in Ethiopia. According to the NBE
Directive SBB-43-2008, classification of loans and advances into the five categories:
16
Pass
Loans or advances in this category are fully protected by the current financial and paying
capacity of the borrower and are not subject to criticism. In general, any loan or advance,
or portion thereof, which is fully secured, both as to principal and interest, by cash or
cash-substitutes, shall be classified under this category regardless of past due status or
other adverse credit factors.
Special mention
Loans and advances classified under this category have the following characteristics;
1. Loans or advances with pre established repayment programs past due 30 days or more
but less than 90 days.
2. Overdraft and loans or advances that don’t have pre established prepayment program,
if
a. The debt remains outstanding for 30 consecutive days or more but less than 90 days
beyond the scheduled payment or maturity date.
b. The debt exceeds the approved limit and interest due or uncollected outstanding for 30
consecutive days or more but less than 90 days. And
c. The overdraft account has been inactive (no debit and credit transaction has been
made) for 30 consecutive days or more but less than 90 days.
Substandard
The following non-performing loans and advances at a minimum shall be classified as
substandard:
but less than 180 days

17
if
b. The debt exceeds the approved limit and interest due or uncollected outstanding for 90
consecutive days or more but less than 180 days. And
Doubtful
doubtful:
but less than 360 days
if
b. The debt exceeds the approved limit and interest due or uncollected outstanding for
180 consecutive days or more but less than 360 days. And
18
Loss
loss:
1. Loans or advances with pre established repayment programs past due 360 days or
more.
if
a. The debt remains outstanding for 360 consecutive days or more.
b. The debt exceeds the approved limit and interest due or uncollected outstanding for
360 consecutive days or more. And
made) for 360 consecutive days or more.
Therefore, as per the above NBE loans classifications, loans are classified as NPL, when it is
classified as Sub Standard, Doubtful and loss.
2.2.4. Approaches of NPL Determinants
As far as NPLs are concerned, the literature identifies two sets of factors to explain the evolution
of NPLs over time. One group focuses on external events such as the overall macroeconomic
conditions, which are likely to affect the borrowers’ capacity to repay their loans, while the
second group, which looks more at the variability of NPLs across banks, attributes the level of
NPLs to bank-level factors. Empirical evidence, however, finds support for both sets of factors.
19
2.2.4.1. Macroeconomic Factors Associated with NPL
For determining NPLs macroeconomic factors may need to be studied. The existing literature
provides evidence that suggests a strong association between NPLs and several macroeconomic
factors. The macroeconomic factors which the literature proposes as important determinants are:
annual growth in GDP, real interest rates, the annual inflation rate, real effective exchange rate,
annual unemployment rate, broad money supply and GDP per capital.
Despite a continuous area of study to confirm the correlation between GDP growth rate and
NPLs the recent studies show that there is a positive correlation between GDP growth rate and
NPLs of commercial banks (Makri et al. 2012; Saba et al. 2012; and Prasanna, 2014). According
to Klein (2013), this is because higher real GDP growth usually translates into more income
which improves the debt servicing capacity of borrowers. Conversely, according to Salas &
Suarina (2002), cited in Klein (2013) when there is a slowdown in the economy the level of
NPLs is likely to increase as unemployment rises and borrowers face greater difficulties to repay
their debt. Alexandri & Santoso (2015) supported a significant relationship between GDP growth
rate and NPLs of banks on their panel data study of Indonesia. Such a significant relation
between GDP growth rate and NPLs of banks has been supported by Louzis et al. (2011) in a
study of Greek banking sector.
Other macroeconomic variable, which was found to affect banks’ asset quality, is inflation. In
this regard higher inflation can make debt servicing easier by reducing the real value of
outstanding loan, but on the other hand, it can also reduce the borrowers’ real income when
wages are sticky. In countries where loan rates are variable, higher inflation can also lead to
higher rates resulting from the monetary policy actions to combat inflation (Nkusu, 2011).
20
2.2.4.2. Bank Specific Factors Associated with NPLs
Apart from macroeconomic variables, there are empirical evidences that suggest several bank
specific factors such as, size of the bank expresses in terms of its total asset, operational
efficiency (ROA and ROE), terms of credit (such as interest rate charged), risk profile (measured
by several proxies such as loans to asset ratio and loans to deposit ratio) are important
determinants of NPLs, because they can cause risky loans. According to Njeru (2012), for
effective management of NPLs, it is very critical for commercial banks to understand and focus
more on the management of bank specific factors which they have more control over and seek
practical and achievable solutions to address NPLs problems.
2.2.4.2.1. Loan Growth and NPL
Excessive lending by commercial banks is identified as an important determinant of NPLs.
Rapid growth of loans is achieved by either reducing interest rate charged to borrowers or by
lending to lower credit quality borrowers. This will lead, through adverse selection reasoning, to
an increase of problem loans (Boudriga et al. 2009). The literature indicates that rapid credit
growth is often related with impaired loans. Bercoff et al. (2002), cited in Messai & Jouini
(2013) demonstrated that credit growth have an impact on the impaired loans. Indeed, excessive
loans offered by banks are usually considered as a main determinant of NPLs (Messai & Jouini,
2013).
2.2.4.2.2. Loan to Deposit Ratio and NPL
Loan to deposit ratio used to measure the liquidity size of the bank and demonstrates the
relationship between loans and deposits. Loan to deposit ratio, according to Suryanto (2015) is
the ratio between the total amounts of credit provided the bank with funds received by the bank
to measure the ability of bank to repay the withdrawal of funds by depositors by relying loans as
21
a source of liquidity. It measures the funds that a bank has utilized into loans from the collected
deposits (Suryanto, 2015).
As the deposits of the banks are growing and loans are not, it shows that banks are risk averse
and lend only to those customers who have good credit history and are able to repay the loan. An
increase in deposits as compared to the loans shows that banks are more concerned with the
quality of loans rather than the quantity and lend only to the quality borrowers. Therefore,
according to previous studies such as Jamel (2014) and Suryanto (2015) loan to deposit ratio
affect NPL.
2.2.4.2.3. Financial Performance and NPL
Bank performance may determine the risk taking behavior of managers. Banks with high
profitability are less pressured to revenue creation and thus less constrained to engage in risky
credit offerings. However, inefficient banks are tempted to grant and to engage in more uncertain
credits to defend their profitability and meet the prudential rules imposed by the monetary
authorities (Boudriga et al. 2009). In fact, according to Mesai & Jounauni (2013) a bank with
strong profitability has less incentive to generate income and therefore less constrained to engage
in risky activities such as granting risky loans. Instead, inefficient banks are obliged to grant
credits considered risky and subsequently achieve high levels of impaired loans.
Banks usually invest to earn a return on their money, and this ratio tells how well they are doing.
The ratio of net income to equity of banks measures their return on equity (Ehrhardt & Brigham,
2009). Apart from other factors associated with NPL, studies suggest that profitability ratio
variables such as (ROE) need to be examined. Banks’ profitability is linked to the risk-taking
behavior. It is often argued that as highly profitable banks have fewer incentives to engage in
high-risk activities, less profitable banks are exposed to engage in riskier activities. Therefore,
22
according to Boudriga et al. (2009); and Louzis et al. (2011) bank’s profitability measures such
as ROE are expected to display a negative relationship with NPL.
2.2.4.2.4. Operational Efficiency and NPL
Operational efficiency also called cost efficiency according to Louzis et al. (2011) is expressed
as a ratio of operating expenses to operating income. The level of bank efficiency by Siamat,
(2005), cited in Suryanto (2015) demonstrated the ability of bank management in controlling
operating expenses to operating income. The bank's operating costs according to Suryanto (2015)
are all costs directly related to the business of banks. These include interest expense, foreign
exchange costs, labor costs, depreciation costs, and others while operating income is a direct
result of the operations of a bank that has been received. Bank operating income comprises
interest income, fees and commissions, foreign exchange income, and other income. It is often
argued that efficient banks are better in managing their resources than inefficient banks they are
in a better position to control the level of their NPLs. Therefore, we can say that efficiency ratio
has a negative relationship with banks NPL.
2.2.4.2.5. Regulatory Requirement and NPL
Capital adequacy ratio (CAR) according to Suryanto (2015) is an indicator of the ability of banks
to offset decline in assets as a result of losses in accordance with the requirement that has been
set by regulatory body, which must always be maintained by each bank as a certain proportion of
the total risk weighted assets. CAR according to Boudriga et al. (2009) is used as a tool to
control excessive risk taking by banks and to prevent them from being insolvent through
recapitalization.
Capital serves as a buffer to absorb losses arising from various risks and banks that have a high
level of solvency ratios will be able to meet the financing of bank assets are risky, so in this case,
23
it can reduce the urge banks to take more risks, which resulted in a decrease in the level of NPL
(Alexandri & Santoso, 2015). As CAR is high enough to cover the potential losses from lending,
the lower will be the level of NPL. Therefore, we can say that CAR is negatively related with the
level of NPL.
2.2.4.2.6. Bank Size and NPL
The size of a bank according to Suryanto (2015) can be judged from the total assets. Boudriga et
al. (2009) indicated that larger banks have more resources, and are more experimented to better
deal with bad borrowers. Small banks, on the contrary, may be exposed to the adverse selection
problem due to the lack of sufficient competencies and experience to effectively assess the credit
quality of borrowers. In addition, income creation pressure is also higher for small banks leading
them to lend to ‘bad’ customers. Bank size is also used as proxy for diversification opportunities.
Inline to this, Salas & Saurina (2002), cited in Louzis et al. (2011) argue that bigger size allows
for more diversification opportunities. Hence, as the size of the bank increases NPL will reduce.
Therefore, we can say that bank size (expressed in terms of total asset) and NPL are negatively
related.
2.3. Empirical Literature
In the lending system of banks various factors are contributing to the NPLs. Though such factors
are open to an area of research, to be effective in managing the limited resources of the banks it
is crucial to know these factors and take measures by reviewing related studies and the work of
the various researchers in the area. Hence, section follows presents recent studies that have been
conducted in foreign countries thematically followed by a review of related recent studies that
have been conducted in the Ethiopian context.
24
Several studies have been conducted on NPL and its bank specific determinants. The study of the
bank specific factors associated with NPLs of banks varies across countries. There are several
empirical studies suggest that factors specific to the bank are important determinants of NPL,
because they can cause risky loans. This section reviews the empirical studies on the bank
specific determinants of NPLs conducted on foreign countries.
Loan Growth and NPLs
Several studies show different results regarding the relationship between loan growth rate and
NPL. Boudriga et al. (2009) reveal that high credit growth is associated with a reduced level of
problem loans in MENA region. According to the study banks that are concentrated on their
credit activity are more likely to evaluate effectively the true credit quality of borrowers. Wanjiru
(2013) also supported the above findings and concluded that the NPLs have negative correlation
with growth in loans in Kenya. On the other hand, the study of Hassan et al. (2015) reveals that
rapid credit growth has a significant impact on NPLs in Pakistan. The study also claims that there are
more chances of high NPLs if advancement of credit by banks is rapid. However, using a sample of
85 banks in three countries (Italy, Greece and Spain) for the period of five years from 2004-
2008, Messai & Jouini (2013) show that, the change in lending by banks does not affect the level
of NPLs contrary to the results found by Boudriga et al. (2009).
Loan to Deposit Ratio and NPLs
Louzis et al. (2011) treated the macroeconomic and bank specific factors as determinants of
NPLs in the Greek banking sector. The authors found that that loan to deposit ratio positively
affect NPL among the bank specific factors studied. Similarly, Jamel (2014) conducted a study
on the crucial bank specific determinants of NPL in Pakistani banking sectors. The author found
that loan to deposit ratio have negatively associated with NPLs. However, Makri et al. (2012) in
25
case of Euro zone and Suryanto (2015) in Indonesia show that loan to deposit ratio has no
significant effect on NPL.
Return on Equity and NPLs
Efficiency of banks is also measured by ROE of banks and its relationship with NPL level has
been studied by various authors. Louzis et al. (2011) show higher NLPs ratios will deteriorate the
performance of banks. Similarly, Makri et al. (2012) identified that strong negative relationship
exists between NPL and return on equity in Euro zone. Shingjergji (2013) confirmed the above
findings and showing a negative relationship between return on equity and the NPLs ratio in the
Albanian banking system. The author argues that an increase of ROE will determine a reduction
of NPLs ratio.
Cost Efficiency and NPLs
Some studies have used operational efficiency as a determinant factor affecting the occurrence of
NPL in various countries. According to Louzis et al. (2011) cost efficiency has effect on NPL on
in the Greece banking system. Vatansever & Hepsen (2013) Inefficiency ratio negatively affects
NPL in Turkey banking system.
Capital Adequacy and NPLs
Among the bank- specific variables that can affect the level of NPLs, we can also mention
capital adequacy ratio (CAR). The previous literatures indicate that CAR is often related with
NPL of banks. Boudriga et al. (2009) analyzed the MENA region banking system and
demonstrated that highly capitalized banks have high level of NPLs. In contrast to the above
findings, Shingjergji (2013); Vatansever & Hepsen (2013); Jamel (2014); and Alexandri &
Santoso (2015) found that there is a negative relationship between CAR and NPLs ratio and
CAR has a positive effect on NPL ratio. The authors argue that When CAR increases, capital
26
reserves owned by banks also increased and can be used to cover the credit risk that has occurred
due to NPLs.
Bank Size and NPLs
Several studies have been conducted to identify the influence of bank size on NPL in various
countries. Louzis et al. (2011) studied the relationship between sizes of the bank (expressed in
terms of its total asset) and NPL in Greece. The authors have shown that the size of banks is
negatively related to the NPL. On the other hand, Alexandri & Santoso (2015) and Suryanto
(2015) indicate that the variable size does not have a significant impact on banks NPL in
Indonesia. The authors argue that although the larger banks have quality resources and a better
ability in the selection and diversification of credit, but the level of NPLs can be comparable to
total loans where large banks tend to have high levels of lending which creates high loan to
deposit ratio.
In Ethiopian context, there appears to be very limited studies on the factors associated with NPLs
of banks. Wonimagegnehu (2012) assessed the bank specific determinants of NPLs in Ethiopian
commercial banking sector and the findings of the study shows that poor credit assessment,
failed loan monitoring, underdeveloped credit culture, lenient credit terms and conditions,
aggressive lending, compromised integrity, weak institutional capacity, unfair competition
among banks, willful default by borrowers and their knowledge limitation, fund diversion for
unintended purpose, over/under financing by banks ascribe to the causes of loan default.
However, the study outcome failed to support the existence of relationship between financial
performance (ROA and ROE), banks size; loan to deposit ratio; regulatory requirements; loan
growth rate and occurrences of NPLs.
27
The study of Zelalem (2012), examined the bank-specific and Macro-economic determinants of
NPLs of commercial banks in Ethiopia. The study adopts a mixed methods research approach by
combining documentary analysis (structured review of documents) and in-depth interviews.
More specifically, the study reviews the financial records of eight commercial banks in Ethiopia
and relevant data on macroeconomic factors considered for the period from the year 2000 to
2011. The findings of the study show that, loan growth, financial performance, operational
efficiency, effective exchange rate, inflation rate and gross domestic product have negative and
statistically significant relationship with banks’ NPLs. On the other hand, variables like bank
size and state ownership have a positive and statistically significant relationship with banks’
NPLs. However, the study fails to see bank specific variables like capital adequacy ratio.
Gadise (2014), examined the macroeconomic and bank specific determinants of NPLs of
commercial banks in Ethiopia using secondary data and quantitative approach. The study found
out that, bank profitability measured in terms of ROE, banks capital adequacy ratio and lending
rate had negative and statistically significant effects whereas bank profitability measured in
terms of ROA had positive and statistically significant effect on NPLs of commercial banks in
Ethiopia. However, the study fails to consider some bank specific variable like cost efficiency,
loan growth and size of the bank and their influence on NPL.
Recently Anisa (2015), using balanced fixed effect panel regression for the data of eight
commercial banks covered from 2004 to 2013 showed that deposit rate, loan to deposit ratio and
lending interest rate had positive and significant impact on banks nonperforming loan. However,
According to the study cost efficiency had negative and significant impact on banks
nonperforming loan. However, the study fails to see some bank specific variables like financial
performance and capital adequacy ratio.
28
From the most recent studies, Endashaw (2015) indicated that, lack of loan monitoring and
follow up, rapid loan growth, poor risk assessment, loan length/period, and non-collateralized
loans are some of the major causes of NPL. Gebru (2015) found that poor credit analysis and
unsound lending practices, lack of focused loan monitoring and follow-up, lenient credit terms
and conditions, compromised integrity, and fund diversion as the major factors that contribute to
loan default. Habtamu (2015) also showed that the major factors affecting NPLs were poor credit
assessment, poor loan follow up, underdeveloped credit culture, lenient credit terms and
conditions, knowledge limitation, compromised integrity, unfair competition among banks, fund
diversion for unintended purpose, shareholders influences are bank specific factors ascribed to
the occurrence of loan default. However, the studies fails to see some bank specific variables like
loan growth rate, loan to deposit ratio, cost efficiency, financial performance and capital
adequacy ratio and their effect on banks NPLs.
In summary, as it have seen there is no similar study on bank specific determinants of NPL in the
context of Ethiopia. Thus, a research undertaken to explore the factors for NPLs in the case of
Commercial bank of Ethiopia is something that would help addressing an important research
gap.
2.4. Identification of Knowledge Gap
In line with the above theoretical as well as empirical review there is no global standard to define
NPLs at practical level. NPL is loan either in default or close to being in default. NPL is not only
harm to banks, but also it is danger for the overall economy. It also revealed that banks NPL can
be affected by bank specific and Macroeconomic factors.
Various bank specific factors are studied around the globe and the most crucial bank specific-
factors associated with the occurrence of NPL of banks vary across countries. For instance,
29
Boudriga et al. (2009) conducted their study by considering rate of credit growth, capital
adequacy ratio, return on asset ratio, loan loss provision to total loans ratio and bank size (total
asset ) as a bank specific factors associated with NPLs in MENA region. Louzis et al. (2011)
considered cost efficiency, return on equity, size (total asset) and leverage ratio in Greece
banking system. Makri et al. (2012) considered loans to deposits ratio, return on assets and return
on equity as bank specific factors associated with NPLs in Euro zone banking system. Messai &
Jouini (2013) considered in their study that return on assets, the change in loans (rate of loan
growth) and the loan loss reserves to total loans ratio as bank specific factors associated with
NPLs in (Italy, Greece and Spain). On the other hand, Vatansever & Hepsen, 2013 considered
inefficiency ratio, return on equity, capital adequacy ratio and loan to asset ratio as bank specific
factors associated with NPLs in Turkey banking system.
It has seen that in the previous studies the bank specific factors associated with NPL varies
across countries and there is no as such study that indicates the relationship between the most
crucial bank specific factors and NPLs in our country particularly in Commercial bank of
Ethiopia as if it is well known in the past years in providing loans and advances to various
sectors of the county’s economy. Therefore, this research will contribute towards filling the gap
by identifying and analyzing the most crucial bank specific factors that affect level of NPLs
particularly in the case of Commercial bank of Ethiopia in context of the available literature in
the area.
2.5. Conceptual Framework
The main objective of this study is to investigate the most important bank specific factors
associated with the occurrence of NPL in Commercial Bank of Ethiopia using variables that have
been studied by previous researchers. To this end, the researcher developed the conceptual
30
framework of the study, to better comprehend the most important bank specific factors
associated with the occurrence NPL identified in the theoretical and empirical literatures, and to
understand their relationship with the problem. The framework is constructed mainly in
reference to the studies done by Boudriga et al. (2009); Louzis et al. (2011); Makri et al. (2012);
Messai & Jouini (2013); Shingjergji (2013); Vatansever & Hepsen (2013); Jamel (2014);
Alexandri & Santoso (2015); and Suryanto (2015).
The research investigates the bank specific factors. These factors include loan growth rate; loan
to deposit ratio; capital adequacy ratio; cost efficiency ratio; return on equity; and bank size.
Thus, Figure 1 which is the conceptual framework summarizes the main focus and scope of this
study in terms of variables included.
31
Figure 2.1: Conceptual Framework of Bank Specific Factors that affect NPLs
LGR
SIZE
LDR
NPLs
ROE
CAR
CER
Note: NPLs (Non-performing loans), LGR (Loan growth rate), LDR (Loan to deposit ratio),
CAR (Capital adequacy ratio), ROE (Return on equity), CER (Cost efficiency ratio) and SIZE
(Bank size).
Source: Own summary referring from previous researchers (2016).
2.6. Description of Conceptual Framework and Summary of the study variables
The selection of the variable for the study is made based on the studies undertaken by various
researchers as describe in the Table 3.1.
32
Table 3.1: Summary of the study variables
Variables Proxy Expected Sources

sign
Dependent Variable
Non-Performing loans Bad loans/ Total loans (Saba et al. 2012; Vatansever
& Hepsen, 2013; and
Suryanto, 2015).
Explanatory Variables
Loan Growth Rate (Loan t+1) – (Loan t)/ (Loan t) + Boudriga et al. (2009); and
Messai & Jouini (2013).
Loan to Deposit Ratio Total Loans/ Total Deposits + Makri et al. (2012); Jamel
(2014); and Suryanto (2015)
Cost Efficiency Ratio - Louzis et al. (2011);

Operating Expenses/ Vatansever & Hepsen (2013);
Operating Income and Suryanto (2015).
Return on Equity Net Income/Equity - Louzis et al. (2011); Makri et

al. (2012); and Shingjergji
(2013).
Capital Adequacy ratio Capital/Total Asset - Boudriga et al. (2009);
Shingjergji (2013);
Vatansever & Hepsen (2013);
Jamel (2014); Alexandri &
Santoso (2015); and Suryanto
(2015).
Asset Growth Rate (Asset t+1) – (Asset t)/ (Asset t) - Louzis et al. (2011), Messai
& Jouini (2013), Alexandri &
Santoso (2015) and Suryanto
(2015).
Source: Compiled by the researcher from various literatures (2016).
Notes: A positive sign “+” indicates direct impact; whereas a negative sign “–” indicates an
inverse impact of explanatory variables on dependent variable.
33
CHAPTER THREE: RESEARCH METHODOLOGY
3.1. Introduction
This section, describe the study area, specify the type of research, how the research work is
designed and the methods that the study intend to employ in carrying out the research
undertaking.
3.2. Backgrounds of the Organization
The banking system is the main source of funding in the Ethiopian economy. The current
commercial banking system in Ethiopia comprises 17 banks; 16 privately owned commercial
banks and 1 public owned commercial bank namely: Commercial bank of Ethiopia. The history
of the Commercial Bank of Ethiopia (CBE) dates back to the establishment of the state bank of
Ethiopia in 1942. CBE was legally established as a share company in 1963. CBE is the largest
commercial bank in Ethiopia with a total asset of about 303.6 billion Birr and the number of
employees reached to 22,908 as of June 30, 2015.
CBE was established to perform major banking functions carried out by commercial banks in
Ethiopia for the purpose of realizing of stakeholders’ values through enhanced financial
intermediation globally and supporting national development priorities by deploying highly
motivated, skilled and disciplined employees as well as state-of-the-art technology and with
strong believe that winning public confidence is the basis of its success with in its organizational
principles and values: integrity, customer satisfaction, employee satisfaction, learning
organization, teamwork and collaboration, public trust, value for money, decentralization and
corporate citizenship.
CBE is supervised by board of directors and the day today functions of the bank are managed by
the President. The Bank has a process -oriented corporate structure each process headed by a
34
process owner. CBE performs its operations through its core and support processes. The core and
support processes further divided in to sub-processes for various responsibilities and headed by
manager. The bank is located at national level in every part of the country and addresses the
public banking needs through its branches and district offices. As per the information obtained
from to the company’s official website on January 19, 2016 as of December 31, 2015 the banks’
branch expansion reached to 1005 trough out the country (http:// www.combanketh.et).
Moreover, the bank has opened its subsidiary in south Sudan and has been in the business since
June 2009.
The bank has interdependent relationships with 720 correspondent banks of which the bank has
50 accounts in renowned foreign banks like Commerz Bank A.G., Royal Bank of Canada, City
Bank, HSBC Bank, a SWIFT bilateral arrangement with more than 700 others banks across the
world, pioneer to introduce Western Union Money Transfer Services in Ethiopia early 1990s and
currently working with other 20 money transfer agents like Money Gram, Atlantic International
(Bole), Xpress Money Transfer service.
As per the NBE (2015) annual report, commercial bank of Ethiopia manages total assets
equivalent to 43.5% of the total assets managed by all banks. The total asset of the bank
increased from 74.2 billion Birr in 2010 to 303.6 billion Birr in 2015 showing 229.4 billion Birr
increment in its six years of operation. According to the report, CBE alone have 51.3 % share of
loan and advances provided to the economy as of June 30, 2015 (NBE, 2015). The loan and
advances to customers increased from 22.2 billion Birr in 2010 to 111 billion Birr in 2015
showing 88.8 billion Birr increment in its six years of operation. Therefore, the current study
investigates the most important bank specific factors associated with NPLs of commercial bank
of Ethiopia (CBE), where the majority of the assets of the sector (43.5%) managed and the
35
majority of loan and advances of the economy (51.3 %) are provided using 14 years of secondary
data of some variables from 2002 to 2015, interviewing some selected employees of the bank
who are assigned in purposely selected processes or departments engaged in credit and related
responsibilities and emphasizing Head Office for it is deemed to provide the bank‘s overall
financial performance and relevant data for the study.
3.3. Research Design and Strategy
3.3.1. Research Design
A research design according to Zikmund, Babin, Carr & Griffin, 2009 is a master plan that
specifies the methods and procedures for collecting and analyzing the needed information. A
research design provides a framework or plan of action for the research. It is useful to determine
which research approach is being implemented when conducting a research.
As the overall purpose of the study is to investigate the factors that affect NPLs of Commercial
Bank of Ethiopia, and the study is interested in examining the statistical relationship between the
bank specific factors and the problem, there are perhaps several other factors that influence NPL
apart from the variables identified in the study. Therefore, explanatory research design is
appropriate to examine the relationship between NPLs and bank specific variables.
3.3.2. Research Strategy
In order to investigate the factors that affect NPLs of CBE, this study employed mainly
quantitative research strategy. In addition, in order to better understand the nature of the problem
and to increase to scope of inquiry of the bank specific factors that were not addressed by the
quantitative part the study also employed qualitative research strategy as well. Although, the
quantitative method was dominantly used to investigate determinants of NPLs of CBE Following
36
to this, the qualitative method was used to support the quantitative findings and to gain additional
insight into the factors that may affect NPLs of CBE.
3.4. Data Type and Source
Based on the objectives of investigating the factors that affect NPLs of CBE, the study employed
quantitative data type which is time serious and it covers 14 years from 2002 to 2015. In
addition, to find out the most crucial bank specific factors that affect NPLs of CBE the study also
employed qualitative data type.
The study used both primary and secondary data sources. Audited financial reports, published
annual reports and unpublished performance reports of the bank were the main secondary data
sources for the study to obtain the financial data. Credit experts of the bank were the sources for
the primary data.
3.5. Data Collection Methods and Procedure
3.5.1. Data Collection Methods
In order to achieve the research aim, the study adopted secondary data. The secondary data
collected 14 years time series data (from 2002 to 2015) of the study variables: Non-performing
Loans; Loan Growth Rate; Loan to Deposit Ratio; Capital Adequacy Ratio; Cost Efficiency
Ratio; Return on equity; and Size (total asset) trough structured review of documents. The
underlined reason for selection of a period of fourteen years time series data was the availability
of the required data of the study variables.
To obtain detailed information about the problem and to explore issues in depth, key-informant
interview with experienced bank experts and practitioners in the lending related activities was
conducted. Interview session was purposely conducted for this study in order to obtain valuable
37
data related to the problem and get deep understanding about the most important variables that
affect NPLs of CBE which were not included in the model. The participants were interviewed
about their view on the bank specific factors that affect NPLs of CBE and their view about the
possible remedial actions need to be taken in the future to minimize the problem.
3.5.2. Data Collection Procedures
To obtain secondary data of the study variables, the researcher had computed various financial
ratios. The ratios calculated were:
NPL ratio: measures the ratio of band loans to total loans.
Loan growth rate: measures the rate of the growth of loans.
Loan to deposit ratio: measures the ratio of loans to deposits.
Capital adequacy ratio: measures the ratio of total equity to total assets.
Cost efficiency ratio: measures the ratio of operating expenses to operating income.
Return on Equity: measures the ratio of net income to equity.
Size: measures rate of growth of the asset.
As a procedure while conducting the interview and collecting data the researcher asked the
consent of the interviewee by explaining the purpose of the interview, why the respondents has
been chosen, expected duration of the interview, and how the information obtained kept
confidential. After getting the consent of the interviewee the researcher summarized key data
immediately following the interview using note taking.
3.6. Data Processing and Analysis
3.6.1. Data Processing
As data processing is the critical part of any research regardless of its type, great care and effort
have been invested by the researcher to the maximum possible extent. In the process, the
38
collected secondary data values are edited and the required ratios of secondary data are
calculated and data entered to Statistical Package for Social Sciences (SPSS) software for further
analysis.
3.6.2. Data Analysis
The study employed both quantitative and qualitative analysis. The quantitative analysis of the
study employed both descriptive and inferential analysis with the aid of the SPSS version 20
software. As part of descriptive analysis, measures of central tendency and measures of
dispersions (mean, standard deviation) are used across all variables as a preliminary analysis.
As a part of inferential analysis, Bivariate Pearson’s correlation using one-tailed test was used.
The aforementioned analysis is founded on the fact that the study aimed to investigate the linear
relationship between each independent variable with the dependent variable and to test the
direction of effect between the two variables correlated with prior specific prediction. In
addition, the classical linear multiple regression (CLMR) model was employed to investigate the
significant bank specific factors associated with the problem and the effect of independent
variables on the dependent variable. Finally, the study findings are presented in form of tables
that reflect the statistical results.
As the data obtained from interview are qualitative in nature and a detailed analysis will not be
made, rather the qualitative data which was obtained from the interview analyzed thematically.
To analyze the interview data, the researcher read through the interview responses and looks for
themes among the issues raised by participants. Then, the variety of themes obtained grouped in
to meaningful theme. Next, the analysis was done by identifying categories of the core themes
from the data that relate the researcher focus and the research objectives. Finally, the key ideas
and results of the themes related with the study are summarized, analyzed and interpreted.
39
3.7. Model Specification
The determinants of NPLs have been analyzed and studied using various empirical models in the
previous literature. So as to investigate the bank-specific factors associated with the occurrence
of NPLs, the following general multiple linear regression equations were specified:
Yi,t = β0 + βXi,t + μi,t………………………………………………….……………………(1)
Where;
Yi,t - is the NPLs of bank i at time t, with i=1… N, t=1… T
β0 - is a constant term,
Xi,t - is the explanatory variables(bank specific variables) of bank i at time t and
μi,t - the disturbance term.
As noted in Brooks (2008), the rational for the inclusion of disturbance term are: first, even in
the general case where there is more than one explanatory variable, some determinants of Yi,t
will always in practice be omitted from the model. Second, there may be errors in the way that
Yi,t is measured which cannot be modeled. Finally, there are bound to be random outside
influences on Yi, t that again cannot be modeled. Therefore, based on the above general multiple
linear regression models and on the basis of selected variables for the study the specific
empirical model used presented as follows:
NPL = f (LGR, LDR, CAR, CER, ROE, SIZE)
NPL = β0 + β1 LGR + β2 LDR + β3 CAR + β4 CER + β5 ROE+ β6 SIZE+ μ………………. (2)
Where;
40
NPL= the ratio of non-performing loans to total loans of the bank in year t.
LGR = loan growth rate
LDR = loan to deposit ratio
CAR = capital adequacy ratio
CER = cost efficiency ratio
ROE= return on equity
SIZE= bank size
β0 = is a constant term
β1, β2, β3, β4, β5 and β6= coefficients
μ = error term /residuals
3.8. Ethical considerations
The research gave due consideration to obtain consent from each participant of the study and it
was strictly conducted on voluntary basis. The researcher also tried to respect right and privacy
of the participants for the study. Furthermore, Participants were informed that the information
they provide would be kept confidential and would not be disclosed to anyone else including
anyone in the bank.
In addition, the researcher assured that the findings of the research presented without any
deviation from the outcome. Finally, the researcher has given full acknowledgements to all the
reference materials used for the study.
3.9. Validity and Reliability
To ensure the validity and reliability of the data used in the model, the researcher run two steps
multiple linear regression equations. In the first step all the proposed independent variables were
regressed with respect to the dependent variable. Then, only the significant variables that were
41
found from the first step regressed once again in order to ensure the reliability and validity of the
data used in the model. In addition, to check for the validity of the study parameters and to guard
the study from spurious results, the researcher performed diagnostic tests for classical linear
multiple regression assumptions such as test for Normality, Multicollinearity, Heteroscedasticity
and Autocorrelation.
To ensure the validity of the data obtained from in-depth interview, the target groups to be
included in the study to represent were those who know better about the issue being investigated.
Besides, the researcher assured that this study was reliable in that the respondents were selected
based on their past experience on credit related matters.
42
CHAPTER FOUR: RESULTS AND DISCUSSIONS
4.1. Introduction
The chapter presents the descriptive statistics results of the study variables. In addition, the
chapter presents diagnostics test results of Multicollinearity, Heteroscedasticity, Autocorrelation,
and Normality. Then, the chapter presents results of the correlation and regression analysis and
discusses the results. Finally, the chapter presents results of in-depth interview and discusses the
study results.
4.2. Descriptive Statistics Results and Discussions
This section presents the descriptive statistics of dependent and explanatory variables used in this
study. The dependent variable used in this study was NPL while explanatory variables are LGR,
LDR, CAR, CER, ROE and SIZE.
Table 4.1: Summary of Descriptive Statistics for dependent and independent variables over
the period of 2002-2015
Variables Observation Minimum Maximum Mean Median Stand.Dev Skewness Kurtosis
NPLs 14 .90 53.30 20.59 18.50 18.72 0.329 -1.501
LGR 14 -14 71 15.36 15 22.36 1.146 1.841
LDR 14 30 53 43.38 45 6.85 -0.531 -0.254
CAR 14 4 17.40 9.07 9.34 4.27 0.309 -0.832
ROE 14 20 114.10 60.91 53 31.44 0.483 -1.09
CER 14 19.07 62.56 37.11 37.28 10.57 0.648 1.74
SIZE 14 23 54 27.43 24.40 8.54 2.84 8
(Bank size).
Source: Audited Annual report, Performance report and own computation with the aid of
SPSS Version 20 (2016).
43
As it can be seen from Table 4.1, the mean of NPL was 20.6% with a minimum of 0.9 % and a
maximum of 53.3%. This indicates that, from the total loans that CBE disbursed, an average of
20.6% were being default or uncollected over the sample period. The lowest NPL ratio that CBE
experienced over the sample period was 0.9 %. On the other extreme, the highest NPL ratio of
CBE was 53.3%. The disparity between the minimum 0.9 % and the maximum 53.3% of NPLs
indicate the margin that NPLs ratio of CBE ranged over the sample period. The standard
deviation of (18.72%) of NPL from its mean value also shows the existence of high variation in
terms of loan recovering capacity of CBE over the sample period.
Regarding the descriptive statistics results of independent variables of the model there are some
interesting statistics that have to be mentioned. For instance, the return on equity which was
measured by the ratio of net income to total equity revealed the highest standard deviation
(31.44%), which means, it was the most deviated variable from its mean compared to other
variables in the model. This indicates the existence of high variation of CBE’s operational
efficiency over the sampled period.
Another interesting observation was loan growth rate of the bank which indicated by the range
between 71% and -14%. A negative sign of loan growth indicates the existence of different
conditions that decreased the loans disbursement practice of CBE over the sample period. The
standard deviation of 22.36% also indicates relatively high loan disbursement practice disparity
of CBE over the sample period. The standard deviation of 10.57 % also shows high disparity of
CBE in terms of its cost efficiency. Among bank-specific variables, the smallest standard
deviation was reported in capital adequacy of the bank which was 4.27%. This indicates the
existence of less variation of CBE’s capital adequacy over the sample period.
44
For almost all the variables, the mean and median values lie within their maximum and minimum
values showing a good level of consistency. As can be seen from Table 4.1, the kurtosis value of
five variables is less than 3 suggesting that the series are platykurtic (short-tailed) relative to the
normal. In terms of the skewness, all the variables are positively skewed except loan to deposit
ratio approaching to the normal. In addition, the values for Skewness and the Kurtosis indices are
small which indicates that the variables most likely do not include influential cases or outliers.
Except bank size whose skewness values are far from zero, the rest are showing values closer to
zero; suggesting little or tolerable problem with regard to skewness.
4.3. Results of Correlation Analysis and Discussions
Correlation is a way to index the degree to which two or more variables are associated with or
related to each other. The chief objective is measuring the strength or degree of linear
relationship between two variables. As noted by Gujarati (2004), the most widely used method to
verify the relationship between two variables for continuous data (ratio and interval) was Pearson
correlation. Since the data type for this study was ratio the researcher used the Pearson
correlation coefficient model. The Pearson correlation coefficient ranges from + 1 (that shows
perfect positive relationship) to -1 (that shows perfect negative relationship).
Table 4.2: Summary of Correlation between dependent variable and independent variables
NPL LDR CAR ROE CER LGR SIZE
NPL 1 -0.25 -0.740 -0.684 -0.176 -0.289 -0.383
Sig.(one- - 0.466 0.001 0.004 0.273 0.158 0.088
tailed)
45
(Bank size).
Source: Own Computation with the aid of SPSS Version 20 (2016).
The result presented in the Table 4.2 outlined the correlation between dependent variable with
independent variables. Correlation doesn’t imply causation rather it shows the magnitude and the
linear relationship between two variables. As revealed in Table 4.2 all the explanatory variables
(LDR, CAR, ROE, CER, LGR and SIZE) are negatively related to the dependent variable (NPL).
Specifically, Capital Adequacy ratio (CAR) is negatively correlated with Non- Performing Loan
(NPL) and the linear relationship between CAR and NPL is statistically significant at both 1%
and 5% level of significance. As also revealed in Table 4.2 Non Performing Loan (NPL) is
negatively correlated with Return on Equity (ROE) and the relationship is statistically significant
at 5% level of significance. The linear relationship between the rest of the independent variables
(LDR, CER, LGR and SIZE) and NPL is negative and statistically insignificant at both 1% and
5% level of significance.
4.4. Tests for Classical Linear Regression Model Assumptions
Before directly dealing with the regression model the researcher conducted some important tests
in relating to the classical linear regression model (CLRM) to guard against the possibility of
obtaining and interpreting spurious regression results. The results of the tests are presented in the
following sections. These were required to show that the estimates technique, Ordinary Least
Squares (OLS) had a number of desirable properties usually known as Best Linear Unbiased
Estimators (BLUE) and also so that hypothesis tests regarding the coefficient estimates could
validly be conducted. Therefore, the researcher tested for Normality, Multicolinearity,
46
Autocorrelation and Hetroscedasticity and the results of the tests are presented in the following
sections.
4.4.1. Multicolinearity Test
The result of the test for existence of Multicollinearity between independent variables using the
correlation matrix is presented in Table 4:-
Table 4.3: Summary Correlation Coefficients of Independent Variables
LDR CAR ROE CER LGR SIZE
LDR 1
CAR 0.238 1
ROE 0.610 0.485 1
CER -0.411 0.072 -0.178 1
LGR 0.477 0.436 0.548 -0.185 1
SIZE 0.117 0.188 0.289 -0.417 0.207 1
(Bank size).
Source: Own Computation with the aid of SPSS Version 20 (2016).
According to Gujarati (2004), if one explanatory variable has shown exact linear relation with
the other explanatory variable, then the model suffer from perfect Collinearity, as a result it
cannot be estimated or satisfied the OLS properties. For this purpose the researcher used Pearson
movement correlation coefficient. Besides, the researcher used Variance Inflation Factor (VIF)
and tolerance level (TOL) in order to measure Colinearity or Multicolleniarity.
47
As noted by Gujarati (2004), the rule of thumb suggested that if variance inflation factor (VIF)
exactly or exceeds 10 there is a problem of Multicolinearity and if the VIF less than 10 is
tolerable. In addition, the rule of thumb also suggested that the problem of Multicolinearity
decreases as the tolerance level (TOL) approaches to 1. As shown Appendix 3.4 the researcher
measured the VIF and gets a value of less than 10 for all the independent variables and TOL was
far from zero and approaches to 1. In addition, the mean VIF of the variables was found to be
1.747 which was much lower than the threshold of 10.
Various Authors have suggested that the correlation coefficient among the variables can be used
as a detection mechanism for Multicollinearity problems. Malhotra, 2007 suggested that the
Multicollinearity exists if the correlation between two explanatory variables is more than 0.75.
Kennedy, 2008, cited in Zelalem, 2013 also suggested that Multicollinearity problem exists when
the correlation coefficients among the variables are greater than 0.70. There are also various
Authors such as Gujarati (2004) who suggest for the presence of sever Multicollinearity if
correlation coefficient is in excess of 0.8. Despite a variation on the threshold value of the
correlation coefficient for Multicollinearity problems among the authors, as shown in Table 4.3,
in this study there is no correlation coefficient among variables that exceeds the tolerable level as
suggested by previous literatures. Therefore, the results of the VIF, TOL and correlation
coefficients showed that there is no problem of Multicollinearity between variables in the model.
4.4.2. Hetroscedasticity Test
Heteroscedasticity occurs when the error variance has non-constant. Stated equivalently, the
variance of the observed value of the dependent variable around the regression line is non-
constant. Each observed value of the dependent variable as being drawn from a different
conditional probability distribution with a different conditional variance.
48
The study examined scatter plot of the residuals against the predicted values to evaluate whether
the homogeneity of variance assumption is met. If it is met, there should be no pattern to the
residuals plotted against the predicted values. In the scatter plot shown in Appendix 3.7, it can
be seen a staircase pattern, which suggests Heteroscedasticity is not a problem for the model,
(i.e., homogeneity of variance assumption is not violated).
4.4.3. Normality Test
One of the assumptions of classical linear regression model (CLRM) is the normal distribution of
the residual part of the model. As noted by Gujarati (2004), OLS estimators are BLUE regardless
of whether the disturbances are normally distributed or not. If the disturbances (ui) are
independently and identically distributed with zero mean and constant variance and if the
explanatory variables are constant in repeated samples, the OLS coefficient estimators are
asymptotically normally distributed with means equal to the corresponding coefficients (β’s).
The histogram of residuals allows us to check the extent to which the residuals are normally
distributed. The residuals histogram in Appendix 2.2 shows a fairly normal distribution and all
the variables are positively skiwed which is more of approached to normal distribution. Thus,
based on these results, the normality of residuals assumption is satisfied. So, the researchers
concluded that the study result analysis of the explanatory variable is normally distributed as
expected.
4.4.4. Autocorrelation Test
According to Gujarati (2004), the best renowned test for detecting serial correlation is Durbin
Watson test. The Durbin Watson statistics has a value between 0 and 4 both inclusive.
Accordingly, if the d computed nearest to 2 in application, it is assumed that there is no
autocorrelation problem. Thus, as shown in Appendix 3.2 the computed “d” in this study was
2.029 which are nearest to 2 implying the absence of autocorrelation problem. Thus, this implies
49
that error terms are not correlated with one another for different observation in this study. In
addition, as noted in Brooks (2008), the rejection / non-rejection rule would be given by
selecting the appropriate region from the following figure:
Figure 2: Rejection and non-rejection regions for Durbin-Watson Test
Figure 2 above shows as Durbin-Watson has 2 critical values: an upper critical value (dU) and a
lower critical value (dL). The Durbin-Watson has below the lower critical value (dL) of 2
indicates the existence of positive autocorrelation. On the other hand, the Durbin-Watson above
the upper critical value (du) of 4 indicates negative autocorrelation. The Durbin-Watson value
between 0 and 4 both inclusive indicates no evidence of problem of autocorrelation. Therefore,
the Durbin-Watson value of 2.029 in the model indicates no evidence of problem of
autocorrelation.
4.5. Results of Regression Analysis and Discussions
As mentioned in the previous chapter, in this study a two step multiple linear regression
equations were run. In the first step (general) regression equation, all the proposed independent
variables (i.e., LGR, LDR, CAR, ROE, CER and SIZE) were regressed with respect to the
dependent variable (NPL). To this end, only the significant variables that were found from the
first step regression equation were regressed once again with respect to the dependent variable.
50
Table 4.4: Definition of Variables in the Model
Variable Code Variable Type Variable Definition
NPL Continuous Non-Performing Loans
LDR Continuous The ratio of Loans to Deposits
CAR Continuous Capital Adequacy Ratio
ROE Continuous Return on Equity
CER Continuous Cost Efficiency Ratio
LGR Continuous Loan Growth Rate
SIZE Continuous Bank Size in terms of its Asset
Source: Researcher own Summary (2016).
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Table 4.5: Summary of First Step Multiple Linear Regression Results
Explanatory Variables Coefficient Standard t-statistics Prob.
Error
Loan to Deposit Ratio (H2**) 1.231 0.364 3.320 0.012**
Capital Adequacy Ratio (H4**) -2.127 0.488 -3.683 0.003***
Return on Equity (H5**) -0.456 0.082 -3.928 0.001***
Cost Efficiency Ratio (H3*) -0.277 0.206 -0.499 0.220*
Loan Growth Rate (H1*) 0.120 0.097 0.417 0.256*
Bank Size (H6*) -0.477 0.23 -1.962 0.086*
Constants 35.782 21.289 1.681 0.137
R-squared 0.941 Prob (F-Statistics) 0.001
Adjusted R-squared 0.891 Durbin-Watson 2.029
F-Statistics 18.706
*Insignificant, ** Significant at 5% and *** Significant at 1% Probability level.
H** accept the Hypothesis and H* reject the Hypothesis.
Source: Own computation via SPSS Version 20 (2016).
4.5.1. Goodness of Fit Statistics
According to Brooks (2008), goodness of fit statistics intended to show how well does the model
containing the explanatory variables that can explain variations in the dependent variable. As
revealed in Table 4.5, the adjusted R-Squared (coefficient of determination) of the model was
0.891. The result suggested that, the change in annual loan growth rate, loan to deposit ratio,
capital adequacy ratio, return on equity, cost efficiency ratio and bank size (in terms of total
asset) collectively explain 89.1% of the variation in NPLs ratio of CBE. To the contrary, the
52
remaining 10.9 % of changes on the NPL of CBE were explained by other factors which were
not included in this study. Besides, the adjusted R-Squared values shows that the overall
goodness of the model. Accordingly, the value of R-Squared revealed that the model used in this
study has good or statistically healthy.
In addition, F-statistic results which tests for the joint impact of all explanatory variables on the
dependent variable can also be used to test the fitness of the model at a recommended value of
greater than 5. As it can be seen from Table 4.5 the F-Statistics value of 18.706 justifies the
fitness of the model for estimation. A corresponding p-value of zero attached to the test statistic
shows that the null hypothesis that all of the slope parameters are jointly zero should be rejected
even at 1 percent level of significance. In addition, as per the regression result shown in Table
4.5 the p value for F statistic is < .05. This means that at least one independent variable is a
significant predictor of NPL. Thus it can be concluded that, all the independent variables used in
this study collectively, were good predicators of NPL in CBE.
4.5.2. Screening the Model
Given that (LGR, CER and SIZE) are not significant we remove them from the analysis and refit
the model. Accordingly as per the regression result obtained from Table 4.5, the revised list
variables are: Loan to Deposit Ratio, Capital Adequacy Ratio and Return on Equity.
53
Table 4.6: Summary of Second Step Regression Results
Explanatory Coefficient Standard t-statistics Prob.
Variables Error
LDR 1.582 0.356 4.441 0.001
CAR -2.146 0.517 -4.150 0.002
ROE -0.476 0.086 -5.518 0.000
Constants 0.383 13.704 0.28 0.978
R-squared 0.894 Prob(F-Statistics) 0.000
Adjusted R-squared 0.862 Durbin-Watson 1.698
F-Statistics 28.156
Source: Own computation via SPSS Version 20 (2016).
As mentioned earlier, only the significant variables (LDR, CAR, ROE) that were found in the
first step regression analysis were regressed once again in order to ensure the reliability and the
consistency of the first step regression results (both in terms of the coefficient estimates and the
level of significance). Table 4.6 shows the second step multiple regression results in which the
insignificant variables (LGR, CER and SIZE) were drop. Comparing the results of the two
regression analysis, major differences were not found. As shown in Table 4.6, the adjusted- R
squared (86.2%) statistics in the second step regression were closer to the adjusted- R squared
(89.1%) results obtained in the first step regression. Similarly, the results of Durbin-Watson
statistics in both the first and second step regression were to the nearest. In addition, significant
variables that were found in the first step regression were remained significant (with the same
significance level) in the second step regression. Moreover, the sign and the magnitude of
54
coefficient estimates in both the first and second step regression were much similar. This
confirms that the variables removed from the preliminary model were useless in predicting NPL.
In addition, as shown in Table 4.6 all sig < .05 all the predicators in the model are significant and
should be retained. Based on the above results, it can be concluded that the results obtained from
the first (general) regression analysis were consistent with the result of the second regression
analysis, which enhanced the reliability, validity and consistency of the data used in the model.
4.5.3. Interpretation and Discussion on the Significant Independent variables
The contributions of each individual variable to the explanations of the occurrence of NPLs were
explained in the regression model in Table 4.6, shows that three variables, among the six
regressors included in the model, were found to be statistically significant at 5% level of
significance. Variables that were found to be statistically significant include: Loan to Deposit
Ratio (LDR), Capital Adequacy Ratio (CAR) and Return on Equity (ROE). Those variables were
found to be important factors that influence NPLs in the study area. On the other hand, the rest
three variables namely: Cost efficiency Ratio (CER), Loan Growth Rate (LGR) and Bank Size
(SIZE) were statistically insignificant at the acceptable 5% level of significance.
The coefficient estimates of the significant independent variables that is Loan to Deposit
Ratio(LDR), Capital Adequacy Ratio(CAR) and Return on Equity(ROE) were 1.231, -2.127 and
-0.456. In light of the above summarized regression model the possible discussions and
explanation for each significant independent variable as follows:
Loan to Deposit Ratio (LDR) and NPL
Considering the model, the relationship between loan to deposit ratio and NPLs was positive as
expected and statistically significant at 5% level of significance. The slope of LDR is 1.231.
This means that for every one percent increase in loan to deposits, predicted NPL increase by
55
1.231 percent, after controlling other independent variables included in the model. In other
words, NPLs ratio increases by 1.231 percent when LDR increases by one percent keeping other
factors constant. The result suggests that NPLs is more severe when there is higher LDR in the
bank. Hence, the possible explanation may be if the increasing rate of banks’ lending is high as
compared to the increasing rate of deposits, the level of NPLs will increase. This is because of
the fact that, at the time of low LDR, banks will have the tendency of lending to the low quality
borrowers in order to earn more from the idle money and don’t follow the standard loan
collection practices, which leads to the growth in the level of NPLs. Therefore, the researcher
accepted the claim that there is a positive and statistically significant relationship between LDR
and NPL (H2).
It can be seen from the model that LDR was the most crucial factor in explaining the occurrence
of NPL in CBE. The result of this study as hypothesized confirms the previous findings of
Louzis et al. (2011) in the Greek banking sector. However the study result contradicts with the
previous findings of Suryanto (2015) in Indonesia that found LDR has no significant effect on
NPL.
Capital Adequacy Ratio (CAR) and NPL
The coefficient estimate of CAR in the model revealed a negative and statistically significant
association with NPL at 5% level of significance. The slope of capital adequacy (CAR) is -2.127.
This means that for every one percent increase in capital adequacy, predicted NPL decrease by
2.127 percent, after controlling for other variables included in the model. The magnitude of the
coefficient indicated that NPLs ratio decrease by percent 2.127 when CAR increases by one
percent, keeping other independent variables constant. Therefore, the researcher accepted the
claim that there is a negative and statistically significant relationship between CAR and NPL
(H4).
56
The result of this finding as hypothesized confirms negative and statistically significant
relationship between CAR and levels of NPLs in CBE by confirming the previous findings of
Shingjergji (2013); Vatansever & Hepsen (2013); Jamel (2014); and Alexandri & Santoso (2015)
and the arguments that well capitalized banks are better able to absorb losses arising from
various risks than less capitalized banks. However, the result contradicts with the study findings
of Boudriga et al. (2009), who analyzed the MENA region banking system and that demonstrated
highly capitalized banks have high level of NPLs
Return on Equity (ROE) and NPL
The relationship between ROE and NPLs was negative and statistically significant at 5% level of
significance. The slope of ROE is -0.456. This means that for every one percent increase in
ROE, predicted NPL decrease by 0.456 percent, after controlling for other variables included in
the model. The result indicated that NPL ratio decrease by 0.456 percent when ROE increases by
one percent, keeping other independent variables constant. Therefore, the researcher accepted the
claim that there is a negative and statistically significant relationship between ROE and NPL
(H5).
The result confirms the findings of Louzis et al (2012); Makri et al. (2012); and Shingjergji
(2013) and showing that a negative and statistically significant relationship exists between the
performance of the bank in terms of ROE and levels of NPLs in CBE. This implies that
deterioration of profitability ratio in terms of ROE leads to higher NPLs. This negative and
significant impact of ROE on the levels of NPL indicates the existence of better management of
funds invested in commercial bank of Ethiopia.
57
4.6. Results of Key-Informant Interview
The purpose of qualitative research approach in this particular study was to supplement the
quantitative approach and to investigate other factors that could not obtained from secondary
sources. Accordingly, key informant interview with 12 senior bank experts was conducted. The
interviewees were those involved in lending operation that had minimum of 5 years credit
experience. To this end, the interview questions were focused on the identification of the factors
affecting the NPLs of Commercial Bank of Ethiopia in general by giving due attention on factors
that were not incorporated in the quantitative part of this study. In addition, the interview
questions tried to identify those bank specific factors that can influence NPLs of commercial
bank of Ethiopia, the most important bank specific factors associated with NPL among the
influential factors, those influential factors other than the bank specific factors leads to the
occurrence of NPL and their general opinion in mitigating the NPL problem.
As per the interview results, the general reasons which lead to NPLs in Commercial Bank of
Ethiopia can be grouped into the following two major themes: bank related factors and borrowers
related factors.
4.6.1. Bank Related Factors
Under this theme the issues related to the bank specific factors related to the bank raised by the
respondents summarized below:
Poor Credit Risk Assessment
Most respondents declared that as a guiding principle, the bank uses the five C’s (Character,
Capacity, Collateral, Capital and Condition) of credit assessment. However, most respondents
argue that in practice it is clearly seen that little emphasis was given to the guiding principles of
credit assessment (the five C’s) in the bank which attributes to the occurrence of bad loans. The
58
respondents also said that if the bank knows about the borrowers’ previous credit history, paying
capacity, the market value of the security provided, capital invested and the terms and condition
of credit it will lead to high loan quality.
On the other hand, the borrowers which are admitted by compromising credit risk assessment
conditions usually default. In addition the respondents expressed the concern that, if the bank has
the tendency of taking greater risks in dealing with lending matters then this can increase the
bank’s NPL. The possible explanation here is that, to lend or not, a bank takes into account the
quality of a borrower which is reflected in its past and projected profit performance, the strength
of its balance sheet (for example, capital and liquidity) the nature and market for its product,
economic and political conditions in the country in which it is based, the quality and stability of
its management and its general reputation and standing.
According to the previous studies such as Hassan et al. (2015) there is evidence in the literature
that shows the influence of risk assessment on NPLs of banks, which assesses the repute of
borrowers to repay loan and the market value of securities adequately. According to Hassan et al.
(2015) it is important for the bank to know the purpose of the loan, to assess its validity and to
determine how the funds required for the payment of interest and the repayment of capital will be
regenerated. Therefore, according to the study participants, credit risk, and the ways, in which it
can be identified and minimized, is need to be a key concern for a bank’s management when they
are considering the need to provide loans.
Focusing on Collateral and Cash Flow Based Lending
According to the interview result, focusing on collateral based lending and compromising the
business viability of the borrowers is a cause for the occurrence of NPL of the bank. As the very
purpose of the bank is providing the required finance to the productive sector, selling the
59
collateral should not be the option when the borrower defaults. Instead, careful analysis of the
business viability of the borrowers prior to granting the loan is believed to reduce the NPL of the
bank.
In addition to this, according to the respondents, as a first way out the bank is largely based on
cash flow lending which justifies the ability of the borrower to repay back. However, according
to them repayment of loan by the borrower might not be as predicted basing the cash flow and
leads to default. The explanation raised by the respondents is that, the mere focus of cash flow
based lending miss leads the credit performers while making loan decisions because of
inappropriate credit analysis, poor customer character and credibility, inappropriate forecasting
of business plan and cash flow, etc. Therefore, to address the problem respondents expressed that
due emphasis be given to analyzing the viability of the business of the borrower prior to loan
approval.
Poor Loan Monitoring and Follow-Up
The respondents discussed that; proper loan monitoring and follow-up ensures improved loan
performance and decreases the chance of its default. Lack of continuous loan monitoring and
follow-up on the other hand, contributes to the occurrence of NPL. The possible explanation here
is that, according to Farhan et al. (2012), in societies where people give more importance to
current consumption than investment, they do not mind to spend the borrowed fund for
consumption if they are not strictly followed up. If the lender doesn’t monitor and followed-up
promptly, the borrower may be grateful not to have been embraced and delay payment. As per
the interview result, loan monitoring is identified as an important bank specific factor that affects
the occurrence of NPL of CBE. Banks concentrate more on monitoring the NPLs have lower
NPLs and inefficient loan monitoring causes of NPLs. Therefore, this variable as mentioned by
the respondents is expected to have a significant effect on NPLs of banks since the previous
60
literature such as Richard (2011) and Hassan et al. (2015) shows that poor monitoring is often
associated with higher NPLs.
Poor Banker’s Skill in Dealing with Lending Matters
Respondents also expressed their concern on the banker’s qualification and experience in dealing
with lending matters. Certainly, respondents said that lending officer’s qualification, experience
and capability plays a key role in making wise loan decisions. The possible explanation here is
that, the knowledge and experience of lending officers in dealing with lending matters enables
them to make proper loan processing and analysis and make the right and wise loan decision,
these all factors altogether lead to an increase in quality of loans.
Undiversified Loan Products
Respondents discussed that lack of diversified loan products in the bank has a tendency for the
occurrence of NPL. According to them, sticking in few loan products and limiting the allocation
of funds to particular sectors forces the borrower to engage in unintended and unproductive
sector with the mere purpose and intention of getting the loan which leads them to default.
Hence, diversified loan products have an important role in addressing the need of the borrowers
so that they are able to get the required finance for their intended business which leads them to
make profit and pay back the loan as agreed.
Short Loan Life
As per the interview result, respondents also discussed that shorten loan life leads to the
occurrence of NPL. According to them, shorter loan life has high tendency to turn to NPL than
longer loan period. The possible explanation is that, as the life of the loan is shorter borrowers
are obliged to re pay highest amount as per the agreement and creates burden on them which
leads to NPL of the bank. Therefore, respondents claimed that, the bank needs to give reasonable
61
loan term and conditions to the borrowers so that they can pay easily which in turn reduces the
NPL of the bank.
Lack of Credit Advisory Practices
The respondents discussed that most of the borrowers engaged in business had no depth
knowledge about credits and wise use of the borrowed funds. To fill the gap lending institutions
are required to provide advisory services and business guidance prior to granting the loan to
borrowers. The possible explanation here is that, proper advisory service provided by the bank
helps to develop credit orientation of the borrower in effect which leads to reduce the level of
NPL.
4.6.2. Borrowers Related Factors
The second category of theme that was considered as the most important factor associated with
the occurrence of NPL according to the interviewee were borrower related factors. As per the
interview result, providing unreliable information and previous financial performance, using the
loan for unintended purposes that are undesirable from the banks' point of view, lack of borrower
credit worthiness, willful default by the borrowers and borrowers poor credit knowledge and
orientation were the most borrowers related factors associated with the occurrence of NPL in
CBE.
62
CHAPTER FIVE
SUMMARY, CONCLUSION AND RECOMMENDATIONS
5.1. Introduction
On the basis of the findings of the results presented in the preceding chapter, this chapter
attempts to give summary, conclusions and recommendations.
5.2.Summary
The major objective of the study was to investigate the factors that affect NPLs in the study area.
Various factors are responsible for the occurrence of NPL. The literature identifies two set of
factors as causes of NPL: (i) individual bank-specific factors such as loan growth rate,
operational efficiency, return on equity, loan to deposit ratio, bank size, etc. (ii) macroeconomic
indicators which include gross domestic product (GDP) growth rate unemployment rate, rate of
inflation, etc. However, the availability of data on the limited variables has allowed the
researcher to explore limited variables. In this study the selected dependent and independent
variables were calculated from the bank’s annual and performance reports. The research
employed the classical linear regression model (CLRM) assumptions proposed for model
estimation.
An explanatory research design was adopted to explain the relationship between the study
variables and NPLs. A combination of qualitative and quantitative research approaches were
employed to collect data. The data sources for the research were both primary and secondary.
The primary data were collected from 12 credit experts using key-informant interview. The
secondary data were collected for a period of 14 years from 2002- 2015 from annual and
performance reports of the bank.
63
The analysis employed both descriptive and inferential statistics. Descriptive statistics were
employed to describe study variables status. Multiple linear regression models was specified and
estimated to identify the significant factors that affect NPLs.
The model estimation results show that the significant variables namely, capital adequacy ratio
and return on equity were inversely related with the dependant variable (NPL) with the prior
expectations in sign and magnitude at less than 5% significance level; and the remaining variable
namely, loan to deposit ratio was found to be positively related with the prior expectations in
sign and magnitude at less than 5% significance level.
On the other hand, the model estimation results also show that the insignificant variables namely,
cost efficiency and bank size were inversely related with the dependant variable (NPL) with the
prior expectations in sign only but not in magnitude at less than 5% significance level; and the
remaining variable namely, loan growth was found to be positively related with the prior
expectations in sign only but not in magnitude at less than 5% significance level.
Generally, results from the regression analysis estimated by multiple linear regression model
showed that loan to deposit, capital adequacy and financial performance (ROE) had a significant
effect on the NPL of CBE. The impact of loan growth, cost efficiency and bank size found to be
insignificant in affecting the level of NPL in CBE.
The interview result found out that the factors that affect NPLs in CBE categorized in to two
core themes: (i) Bank related factors which includes poor credit risk assessment, focusing on
collateral and cash flow based lending, poor loan monitoring and follow-up, poor banker’s skill
in dealing with lending matters, undiversified loan products, short loan life and lack of credit
advisory practices. (ii) Borrowers related factors which include unreliable information, using the
64
loan for unintended purposes, lack of borrower credit worthiness, willful default by the borrower
and borrower poor credit knowledge and orientation.
5.2. Conclusions
The main objective of this research was to investigate factors that affect NPLs in CBE. To
achieve this objective, the study used mixed research approach. More specifically, quantitative
research approach using secondary data. In addition, to have a better insight and to gain a richer
understanding about the research problem, the qualitative method also employed. To this end, the
collected data from CBE over the period of 2002 to 2015 were analyzed using descriptive
statistics, correlation matrix and multiple linear regression analysis. The analyses were made in
line with the stated hypotheses formulated in the study. As a result, the empirical findings of the
study suggested the following conclusions:
The estimation result show that, bank specific variables such as loan to deposit ratio and loan
growth rate are positively related with the level of NPLs in CBE as expected. On the other hand,
the statistical relationship between bank specific variables such as return on equity, capital
adequacy, cost efficiency and bank size was negative as expected. The estimation model also
show that bank specific variables such as loan to deposit, capital adequacy and return on equity
were found to be statistically significant in affecting NPLs of CBE. Thus, H2, H4 and H5
accepted. However, the model also show that bank specific variables such as loan growth rate,
cost efficiency and bank size have statistically insignificant in affecting NPL. Thus, H1, H3 and
H6 rejected.
Variables such as poor credit risk assessment, focusing on collateral and cash flow based
lending, poor loan monitoring and follow-up, poor banker’s skill in dealing with lending matters,
undiversified loan products, short loan life and lack of credit advisory practices, providing
65
unreliable information and previous financial performance by the borrower, using the loan for
unintended purposes that are undesirable from the banks' point of view, lack of borrowers credit
worthiness, willful default by the borrowers and borrowers poor credit knowledge and
orientation were found to be the most important bank specific factors that affect NPLs in CBE.
5.3. Recommendations
Based on the findings of the study, the following possible recommendations were forwarded as
follows:
 Loan to deposit ratio, capital adequacy and financial performance in terms of return on
equity were the significant variables affecting NPLs in CBE. Hence, focusing on these
indicators in the long run could further reduce the probability of loan default.
 The bank need to focus on credit information sharing of other banks and exploit the
application of know your customer (KYC) principle, which plays an important role in
reducing the probability of risk associated with poor credit assessment and the occurrence
of NPL.
 In addition to cash flow and collateral base lending, the bank need to consider other way
outs such as the business viability studies, adequate credit assessment, the trust and credit
worthiness of the borrower, the feasibility of the project and the management and
business experience of the borrower as a lending approach in such a way that minimizes
the probability of default.
 The bank needs to spend more on proper loan monitoring and follow-up, to lower the
level of NPL and developing sound loan recovery strategies. In addition, it is
recommended for the bank to communicate with the borrowers and make signal on a
timely basis regarding their loan repayment status.
66
 The bank need to provide good and up to date training to the lending officers which
increases the skill and capability of them in dealing with lending matters so that they are
able to make wise loan decision which in turn reduces the level of NPL. Since, competent
personnel in the loan processing results in quality loan approval, which will minimize the
amount of NPL.
 The bank should put in place diversified loan products to address the need of the
borrowers so that they are able to get the required finance for their intended business on
which they have a better knowledge and experience with a reasonable maturity period
which do not create additional burden on them.
 The bank should provide business advice and financial counseling to the borrowers on
the wise use of loan.
5.4. Future Areas of Research
The main focus of this research was on investigating the bank specific factors associated with the
occurrence of NPL in the case of Commercial Bank of Ethiopia using selected variables and
sampled periods. However, there are so many bank specific variables that were not included in
this study. Thus, future researchers are recommended to undertake similar study by increasing
the sampled periods and considering additional variables such as, return on asset, loan loss
reserves, lending interest rate, loan to asset ratio and the like on the same bank. Such studies are
useful to validate and confirm the findings of this study.
In addition to bank specific factors, macroeconomic factors, which are not addressed in this
research, also affect the occurrence of NPL. Therefore, it is recommended that a similar study be
conducted by including macroeconomic variables associated with NPLs. Furthermore, future
researches are recommended to be conducted by including the defaulter’s response.
67
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Appendices
Appendix 1: Raw Data

Year NPL LGR LDR CAR CER ROE SIZE
2002 42 -9.3 53 4 43.12 53 23.82
2003 40 -14 43 5 31.53 43 23.91
2004 37.7 -2.7 37 5 43.06 22 24.05
2005 27.5 12.9 38 4 38.78 40 24.22
2006 22.5 -2.8 33 4 33.39 53 24.30
2007 14.5 4.7 30 10 62.56 20 24.50
2008 53.3 43.7 46 9 30.51 30 24.64
2009 36.6 17.1 48 8 19.07 53.9 24.81
2010 1.7 17.9 44 17.4 37 51 25.03
2011 0.9 5 42 11.5 23.61 70.7 54
2012 6.1 71 53 9.68 31.13 114.1 38.4
2013 2.2 20.6 48 13.3 37.56 101.2 23.0
2014 1.4 27 46.38 12.9 43.67 98 24.19
2015 1.8 24 46 13.2 44.62 102.8 25.09
Source: Audited Annual Reports, Performance Reports and own Computation (2016).
Appendix 2: Preliminary Analysis Assumption Test Results
Appendix 2.1: Descriptive Statistics Result
Descriptive Statistics
N Range Minimum Maximum Sum Mean Std. Variance Skewness Kurtosis

Deviation
Statistic Statistic Statistic Statistic Statistic Statistic Std. Statistic Statistic Statistic Std. Statistic Std.
Error Error Error
Loan Growth 5.97

14 85.00 -14.00 71.00 215.10 15.3643 22.35919 499.933 1.146 .597 1.841 1.154
Rate 574
Loan to Deposit 1.82

14 23.00 30.00 53.00 607.38 43.3843 6.84643 46.874 -.531 .597 -.254 1.154
Ratio 979
Capital 1.14
14 13.40 4.00 17.40 126.98 9.0700 4.27465 18.273 .309 .597 -.832 1.154
Adequacy Ratio 245
8.40
Return on Equity 14 94.10 20.00 114.10 852.70 60.9071 31.44258 988.636 .483 .597 -1.094 1.154
338
Cost Efficiency 2.82

14 43.49 19.07 62.56 519.61 37.1150 10.57446 111.819 .648 .597 1.742 1.154
Ratio 614
2.28
Bank Size 14 31.00 23.00 54.00 383.96 27.4257 8.53880 72.911 2.837 .597 8.005 1.154
209
Non Performing 5.00

14 52.40 .90 53.30 288.20 20.5857 18.72193 350.511 .329 .597 -1.501 1.154
Loan 365
Valid N
14
(listwise)
Source: Audited Annual Reports, Performance Reports and Own Computation via SPSS
Version 20 (2016).
Appendix 2.2: Normality Assumptions Test Result (The Histogram of Residuals)
Source: Audited Annual Reports, Performance Reports and SPSS result (2016).
Appendix 2.3: Pearson Correlation Result
Correlations
Loan Loan to Capital Return on Cost Bank Non
Growth Deposit Adequacy Equity Efficiency Size Performing
Rate Ratio Ratio Ratio Loan
Pearson
1 .477 .436 .548* -.185 .207 -.289
Loan Growth Correlation
Rate Sig. (2-tailed) .085 .120 .043 .527 .478 .317
N 14 14 14 14 14 14 14
Pearson
.477 1 .238 .610* -.411 .117 -.025
Loan to Deposit Correlation
Ratio Sig. (2-tailed) .085 .412 .021 .144 .691 .932
N 14 14 14 14 14 14 14
Pearson
.436 .238 1 .485 .072 .188 -.740**
Capital Adequacy Correlation
Ratio Sig. (2-tailed) .120 .412 .078 .806 .520 .002
N 14 14 14 14 14 14 14
Pearson
.548* .610* .485 1 -.178 .289 -.684**
Correlation
Return on Equity
Sig. (2-tailed) .043 .021 .078 .543 .316 .007
N 14 14 14 14 14 14 14
Pearson
-.185 -.411 .072 -.178 1 -.417 -.176
Cost Efficiency Correlation
Ratio Sig. (2-tailed) .527 .144 .806 .543 .138 .546
N 14 14 14 14 14 14 14
Pearson
.207 .117 .188 .289 -.417 1 -.383
Correlation
Bank Size
Sig. (2-tailed) .478 .691 .520 .316 .138 .176
N 14 14 14 14 14 14 14
Pearson
-.289 -.025 -.740** -.684** -.176 -.383 1
Non Performing Correlation
Loan Sig. (2-tailed) .317 .932 .002 .007 .546 .176
N 14 14 14 14 14 14 14
*. Correlation is significant at the 0.05 level (2-tailed).

**. Correlation is significant at the 0.01 level (2-tailed).
Appendix 3: Multiple Linear Regression Results
Appendix 3.1: Variables Entered/Removed a
Model Variables Entered Variables Removed Method
Bank Size, Loan to Deposit Ratio,

Capital Adequacy Ratio, Loan
1 . Enter
Growth Rate, Cost Efficiency Ratio,
Return on Equityb
a. Dependent Variable: Non Performing Loan

b. All requested variables entered.
Appendix 3.2: Model Summary b
Model R R Square Adjusted R Square Std. Error of the Durbin-Watson

Estimate
1 .970a .941 .891 6.18188 2.029
a. Predictors: (Constant), Bank Size, Loan to Deposit Ratio, Capital Adequacy Ratio, Loan Growth Rate, Cost Efficiency Ratio,
Return on Equity
b. Dependent Variable: Non Performing Loan
Appendix 3.3: ANOVA a
Model Sum of Squares Df Mean Square F Sig.
Regression 4289.128 6 714.855 18.706 .001b
1 Residual 267.510 7 38.216
Total 4556.637 13

b. Predictors: (Constant), Bank Size, Loan to Deposit Ratio, Capital Adequacy Ratio, Loan Growth Rate, Cost Efficiency Ratio,
Return on Equity
Appendix 3.4: Coefficients a
Model Unstandardized Coefficients Standardized t Sig. Collinearity Statistics

Coefficients
B Std. Error Beta Tolerance VIF
(Constant) 35.782 21.289 1.681 .137
Loan Growth Rate .120 .097 .144 1.237 .256 .620 1.614
Loan to Deposit Ratio 1.231 .364 .450 3.382 .012 .474 2.111
Capital Adequacy
1 -2.127 .488 -.486 -4.358 .003 .675 1.481
Ratio
Return on Equity -.456 .082 -.766 -5.579 .001 .445 2.248
Cost Efficiency Ratio -.277 .206 -.156 -1.346 .220 .621 1.610
Bank Size -.477 .239 -.218 -1.996 .086 .705 1.418

Appendix 3.5: Collinearity Diagnosticsa
Model Dimension Eigenvalue Condition Variance Proportions

Index (Constant) Loan Loan to Capital Return Cost Bank
Growth Deposit Adequacy on Efficiency Size
Rate Ratio Ratio Equity Ratio
1 6.048 1.000 .00 .01 .00 .00 .00 .00 .00
2 .603 3.168 .00 .54 .00 .00 .00 .01 .00
3 .121 7.081 .00 .31 .00 .00 .33 .13 .04

1 4 .112 7.347 .00 .09 .01 .66 .01 .01 .11
5 .081 8.656 .00 .00 .00 .27 .35 .06 .26
6 .032 13.745 .02 .01 .15 .06 .13 .31 .31
7 .004 39.605 .98 .03 .84 .00 .18 .49 .28

Appendix 3.6: Residuals Statistics a
Minimum Maximum Mean Std. Deviation N
Predicted Value -4.0139 44.6248 20.5857 18.16406 14

Std. Predicted Value -1.354 1.323 .000 1.000 14
Standard Error of Predicted
2.889 5.999 4.253 1.050 14
Value
Adjusted Predicted Value -30.7808 52.7754 19.7260 22.44416 14
Residual -7.92251 8.67519 .00000 4.53626 14
Std. Residual -1.282 1.403 .000 .734 14
Stud. Residual -1.994 2.139 .005 1.113 14
Deleted Residual -19.18023 31.68084 .85976 13.41720 14
Stud. Deleted Residual -2.809 3.365 .025 1.453 14
Mahal. Distance 1.911 11.316 5.571 3.120 14
Cook's Distance .000 3.534 .463 .941 14
Centered Leverage Value .147 .870 .429 .240 14
Appendix 3.7: Heteroscedasticity Test Results (Scatter Plot of the residuals Vs the
predicted values)
Source: SPSS Result (2016).

Appendix 4: Instrument for Key-Informant Interview
1. Summary of the respondent profile

a. Level of education__________________________________
b. Experience on lending________________________________
c. Current position____________________________________
2. Views of the respondents on the bank specific factors that affect NPL of commercial bank of
Ethiopia?
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
3. Respondents recommendation in mitigating NPL problems of commercial bank of Ethiopia?

_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
Thanks for giving your time!

Appendix 5: Interview Guide
I want to thank you for taking the time to meet with me today. My name is Sirak Aynalem
Argaw and I would like to talk to you about your views and experiences on the factors
associated with Non-Performing Loans Specifically, the most crucial bank specific factors
associated with Non-Performing Loans of Commercial Bank of Ethiopia. The interview will take
half an hour. I will be taking notes because I don’t want to miss any of your comments. All
responses will be kept confidential. This means that your interview responses will not be shared
with any one and I will ensure that any information I include in the report does not identify you
as the respondent.
Thank You!!!!!!
Appendix 6: The Framework Approach to Thematic Analysis
Theme: Bank Specific Factors
Interviewee Bank Related factors Borrowers Related Factors
1 “Poor credit risk assessment of the bank,

focusing on collateral based instead of
carefully analyzing business viability of
the borrowers leads to NPL”.
2 “Poor loan monitoring & follow up” “Intentional Presentation of unreliable
financial statements miss-leads the bank
and tends to NPL.”
3 “, Poor loan monitoring & follow up, poor “ unreliable financial statements which
bankers skill in dealing with lending miss-leads the bank and exaggerate the
matters leads to NPL” paying capacity of the borrowers leads to
NPL”
4 “Poor loan monitoring & follow up, “Poor character of borrower, lack of
focusing short term loan (short loan life) business experience of the borrower leads
leads to NPL” to NPL”
5 “Limited loan products and lack of
diversification (sticking in to limited loan
product forces the borrower to engage in to
the business he/she not like with the mere
purpose and intention of getting the loan)
leads to exposure to NPLs”
6 “Poor monitoring & follow-up, poor credit “Lack of borrowers credit worthiness, fund
assessment, banker’s skill” diversion for unintended purpose, poor
capacity of borrowers”
7 “Poor bankers skill, experience &
knowledge in dealing with lending matters,
, poor KYC principle”
8 “Loan life, loan diversity (less diversity
forces customers to take unintended loan)”
9 “Poor credit risk assessment, poor loan
monitoring & follow up”
10 “Loan life, , poor loan monitoring and Fund diversion for unintended purpose,
follow up” willful default by borrowers, poor
experience in business
11 “Poor loan monitoring & follow up Poor “Fund diversion for unintended purpose,
credit risk assessment” willful default”
12 “Poor credit risk assessment, limited credit “Poor credit knowledge and orientation”
advisory activities, focusing on cash flow
lending”

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Mekelle University

College of Business and Economics

Factors Affecting Non-Performing Loans: In Case of Commercial Bank of Ethiopia

A Thesis Submitted in Partial Fulfillment of the Requirements for the Award of

Principal Advisor: Teshome Desta (Assistant Professor)

Sirak Aynalem Argaw

Sirak Aynalem Argaw Date

Principal Advisor Co-Advisor

Teshome Desta (Assistant Prof.) Mearg Tesfay (Assistant Prof.)

Non-Performing Loans: In Case of Commercial Bank of Ethiopia” and submitted in partial

fulfillment of the requirements for the degree of Master of Business Administration in

standards with respect to originality and quality.

Internal Examiner: G/Egziabher Berhane (Ass. Professor)

External Examiner: Abdurezak Mohammed (PhD.)

Chair Person: Hailay G/Tinase (PhD.)

CAR Capital Adequacy Ratio

CBE Commercial Bank of Ethiopia

CER Cost Efficiency Ratio

CGR Credit Growth Rate

CLRM Classical Linear Regression Model

GDP Gross Domestic Product

IMF International Monitory Fund

LDR Loan to Deposit Ratio

LGR Loan Growth Rate

MENA Middle East and North Africa

NBE National Bank of Ethiopia

NPA Non Performing Asset

NPL Non Performing Loan

ROA Return on Asset

ROE Return on Equity

SWIFT Society for Worldwide Interbank Financial Telecommunication

OLS Ordinary Least Square

the research report;

Table 3.1: Summary of the study variables…………………..…………………………………34

Table 4.3: Summary Correlation Coefficients of Independent Variables ………………………51

Table 4.4: Definition of variables in the model …………………..…………………………….55

Table 4.5: Summary of First Step Multiple Linear Regression Results…………………………56

Table 4.6: Summary of Second Step Regression Results………………………………………58

Figure 4.1: Rejection and non-rejection regions for Durbin-Watson Test………………………54

1.2. Background of the Study

development of the economy of a country, banks play an intermediary role by transferring

granted in such a way that earns maximum profit.

portfolio and operational efficiency (Saba et al. 2012).

Commercial Bank of Ethiopia (CBE).

1.3. Statement of the Problem

determinant factors that affect NPLs so as to effectively manage their assets.

bank specific factor that affect NPLs of banks in Indonesia.

over/under financing by banks ascribe to the causes of loan default.

useful to include and study credit performer knowledge and experience.

significance between bank specific factors and NPLs?

1.4. Research Objective(s)

The study has the following general and specific objectives.

1.4.1. General Objective

Commercial Bank of Ethiopia.

1.4.2. Specific Objectives

The study has the following specific objectives as outlined below:-

1. To examine if there is a significant statistical relationship exists between loan

growth rate and NPL in case of Commercial Bank of Ethiopia.

2. To examine if there is a significant statistical relationship exists between loan to

deposit ratio and NPL in case of Commercial Bank of Ethiopia.

3. To examine if there is a significant statistical relationship exists between cost

efficiency ratio and NPL in case of Commercial Bank of Ethiopia.

4. To examine if there is a significant statistical relationship exists between capital

adequacy ratio and NPL in case of Commercial Bank of Ethiopia.